The third quarter of 2017 was a reprise of what we experienced in the first two quarters of the year investment grade corporate bond yields were lower and credit spreads were tighter. As far as fundamentals are concerned, the majority of investment grade corporate issuers are displaying earnings growth and balance sheets are generally in good health. Demand for investment grade bonds has been robust in 2017, and issuers have responded in kind by issuing $1.06 trillion in new investment grade corporate bonds, though this pace of issuance trailed 2016 by 5%. During the quarter, the A Rated corporate credit spread tightened from 0.88% to 0.80% (down 8bps), the BBB rated corporate credit spread tightened from 1.41% to 1.31% (down 10bps) and the Bloomberg Barclays US Investment Grade Corporate Index credit spread tightened from 1.09% to 1.01% (down 8bps)ii. To provide some context, the all‐time tight for the Bloomberg Barclays US IG Corporate Index is 0.54%, last seen in March of 1997, while the all‐ time wide is 5.55%, last seen in December of 2008.
As you can see from the chart above, credit spreads are near multi‐year lows. During times like these, when spreads have continued to move tighter, our experience shows that our client portfolios are best served by investing in high quality companies with durable earnings and free cash flow. In other words, we would rather forgo the extra compensation afforded from a lower quality credit and instead focus on investing in a stable to improving credit. Preservation of capital is a key tenet of our strategy, and we do not feel that the current level of credit spreads is providing adequate compensation for the riskier portions of the investment grade corporate bond market. At CAM, we focus on bottom up research through the fundamental analysis of individual companies and we do continue to see pockets of value in the investment grade market, particularly in the higher quality portions of the market.
While credit spreads tightened during the quarter, the movement in Treasury yields was modestly higher as the 10 Year Treasury yield began the quarter at 2.31% and ended it at 2.33% (up 2bps). The 10 Year Treasury started the year at a yield of 2.45%, so while short term rates have increased as the Fed has implemented two rate increases so far in 2017 (i.e. the 2 Year Treasury ended the quarter 27 basis points higher from where it started the year), intermediate Treasury yields remain lower on the year. When short term rates increase and intermediate/long term rates stay stable or decrease, we refer to this as a flattening of the yield curve. This continuation of lower intermediate Treasury yields and tighter credit spreads resulted in lower corporate bond yields at the end of the quarter, relative to where yields started the year. The Bloomberg Barclays US Investment Grade Corporate Index returned +1.34% for the quarter, outperforming the Bloomberg Barclays US Treasury 5‐10 year index return of +0.46%iii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +1.23% for the quarter which slightly underperformed the Investment Grade Corporate index but outperformed the US Treasury index.
See Accompanying Footnotes
New issuance in the quarter saw issuers price nearly $350 billion in new investment grade corporate bonds, bringing the YTD total to $1.06 trillioniv. We have now eclipsed the $1 trillion mark for the sixth straight year, which speaks to the persistent, global demand from investors searching for yield and income for their portfolios. With low‐ to‐negative yields in global fixed income securities, the US Investment Grade corporate bond market still provides a good alternative for global investors (see chart)v.
The Federal Open Market Committee (FOMC) opted not to raise rates at its September meeting, with the market focused squarely on the December meeting. During its September meeting, the FOMC did provide the long awaited details on its program to gradually reduce the size of its balance sheet. The FED is merely reducing the reinvestment of principal payments from the Federal Reserve’s securities; it is not actively selling its holdings. The FOMC has provided a roadmap of its policy normalization efforts along with a schedule of how it plans to gradually reduce its balance sheet over time (see chart)vi. Like most policy actions, the FOMC has showing a willingness to be flexible, pending new information and economic data, so time will tell if the securities reduction schedule is actually implemented as planned.
While the FOMC has begun a gradual effort to tighten monetary policy, the ECB too has discussed scaling back its monetary easing as soon as January 2018, but the plan is vague at this point and the world will be watching closely for more details when they meet again near the end of October. Meanwhile, the BOJ recently pushed back the window for achieving its 2% inflation target for the sixth time; to around fiscal year 2019, meaning the bank will not embark on policy tightening in the near termvii. Bottom line, we are only in the very early innings of a more concerted effort to tighten monetary policy by global central bankers.
A recurring theme for us in our quarterly notes this year has been the lack of market volatility thus far in 2017, and the third quarter of the year was no different from the previous two in that volatility remained low (previous commentaries can be found at www.cambonds.com). Volatility is a fact of life in the capital markets and we know at some point it will return to the forefront. We feel that the best way we can position client portfolios is to focus on the risks that are within our control –namely the quality of the companies in which we invest. While volatility in See Accompanying Footnotes
credit spreads or interest rates is difficult, if not impossible to predict, it is important to understand the impact that higher yields would have on the corporate bond market especially as it relates to a corporation’s balance sheet, cash flows and credit quality. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 28 years.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.
i Bloomberg September 28, 2017 “Investment‐Grade Issuance Total”
ii Barclay’s Credit Research: Daily Credit Call
iii Bloomberg Barclay’s Indices
iv Bloomberg September 29, 2017 “Robust High‐Grade Bonds Sales of September Likely to Fade” v Federal Reserve Flow of Funds
vi Federal Reserve Bank of New York September 20, 2017 “Statement Regarding Reinvestment in treasury Securities and Agency Mortgage Backed Securities”
vii Japan Times July 20, 2017 “BOJ delays window for achieving 2% inflation target”