In 1827, the Baltimore and Ohio (B&O) Rail Road Company, now part of CSX Corporation, was capitalized with just $5 million. The railroad would stretch from the port of Baltimore to the Ohio River in Virginia. The B&O Rail Road moved goods from the Midwest to the East coast, putting it in competition with the transportation of goods to New York by way of the Erie Canal. The first “locomotives” were powered by a horse that walked on a treadmill which drove a series of gears and wheels. In the early 1800’s, this was considered a major advancement in technology. Today, the industry is a lot more complicated and the focus on technology and efficiency has intensified. As the world continues to grow, so will the demand for a better and more cost effective transportation system. We will explore how the North American rails have performed in recent history and will give some examples of how the industry is preparing for the future. If history is any indication of the future, we expect the railroad industry will continue to shape the development of the North American economy.

The freight railroads in North America form an integrated system with over 140,000 miles of track. Rails transport almost everything including the things that we, as consumers, rely on daily including food products that end up on our kitchen tables, coal used to generate electricity, and lumber used to build our homes. The rail system has become one of the most reliable, safest, and productive in the world. As the economy grows and goods in the U.S. become more global, the demand for cost efficient transport will increase. According to the Federal Highway Commission, U.S. freight shipments will increase from 16.9 billion tons in 2010 to 27.1 billion tons in 2040. In order to compete with other modes of transportation, including pipelines and trucks, rails will need to spend a tremendous amount of money on new and existing infrastructure. Over time, these investments have led to improved service levels which is a key ingredient for more favorable pricing. The rails spend between 17%-20% of their revenues on capital expenditures, which is higher than most other industries. For the six largest rails in North America, this totals to about $14 billion per year. Similar to most other industries, it’s necessary for the rails to always strive to improve their competitive position and look forward to capitalize on budding opportunities. Given the industry’s financial results and other important measures of productivity/efficiency, we believe the large amount of money the industry has invested has been well spent. These business improvements can be accomplished in a number of different ways. We will start off by reviewing some specific measures of productivity and efficiency. Then we will provide some real examples of how dollars are being spent. We believe this will help explain the progress of the industry and why we continue to believe the rail industry will perform well.

Operational Performance

The major railroads report important financial and operational data on a regular basis which makes it easy to track the progress of the industry. We will explore some of this data in the next couple of pages.

 Exhibit 1 (see original PDF for all exhibits, click above) shows three measures of performance for the railroad industry. The first is average train velocity (higher velocity is better). The second is dwell time, or time a railcar resides at a terminal (lower is better). The final is the average of the daily online inventory of freight cars (lower is better). As shown in Exhibit 1, for the last 40 weeks you can see that all of these measures have been going in the right direction. Better performance typically results in lower costs and higher profitability.

The graph in Exhibit 2 illustrates the industry’s attention to improving safety and minimizing the number of accidents, which is a direct result of enhanced employee training and applied leading edge technology. The personal injury frequency index is the number of reportable injuries per 200,000 man hours and the FRA (Federal Railroad Administration) train accident rate is the number of reportable train accidents per million train miles. A continued focus on safety should result in a more fluid rail network, less personal liability, lower cost structure, and the ability to maintain/enhance a high quality base of employees.

Fuel is a large portion of a railroad’s total costs. The ratio of fuel costs to revenue is about 10%. Over the last five years, the amount of revenue ton miles (RTM) per gallon of fuel consumed has trended up (shown Exhibit 3). One of the ways rails have been able to manage this cost is by investing in new locomotives which are much more energy efficient. In addition, one of the most important financial measures to focus on for the rail industry is the operating ratio (Exhibit 3). That ratio is calculated by taking operating expenses (includes labor, materials, fuel, and equipment) divided by revenues. We want to see this ratio getting smaller, which tells us that revenues are growing more quickly than the expenses.

Advancements in Technology

Now it’s time to give some examples of how the rails have been able to get these impressive results. One would not typically expect an age-old industry like the railroad industry to develop and implement the advanced technology that they use on a day-to-day basis.

One of those technologies is an acoustic detector system. Sensors placed on a railway help detect distinct sounds which might be the result of excess wear and tear on a specific piece of equipment. If that piece of equipment can be taken off-line and repaired before it creates a problem, like a derailment, a lot of time and money can be saved. Union Pacific uses special predictive software which analyzes data from acoustic and visual sensors. This kind of technology gives Union Pacific days or weeks notice before something is expected to go wrong. Major derailments can cost $20 – $40 million.

Another important technology uses ground penetrating radar (GPR) to look below the railway track substructure (rocks). Feedback from the radar and sensors is used to check for conditions which might compromise track stability, including excessive water and deteriorating terrain.

Canadian National Railway recently announced that the company will buy 200 super-insulated EcoTherm containers. These containers are specially insulated and eliminate the need for diesel engine powered heaters, which keep temperature sensitive products at a normal temperature for up to ten days. Goods shipped in one of these containers consume 8-11% less fuel than the traditional choice.

There have also been major developments in the area of locomotives. One technology uses special locomotives called distributed power units. These units operate in the middle and/or at the end of a line. This creates less force on the train which results in less wear and tear and higher fuel efficiency. Another new technology, GenSet locomotives, replace older traditional yard locomotives. GenSet uses several smaller engines as opposed to one large engine. This locomotive only uses the required amount of engines for specific tasks, resulting in better fuel efficiency. In the yard, these GenSet’s are expected to reduce fuel consumption by 37%. Some of these locomotives use remote control technology and have no cab.

These are just a few examples of ways that new technology has improved operational efficiency. Technology to look for in the future includes aerodynamic design improvements, rail lubrication processes, laser-based rail inspection systems, and the use of special metals which better resist wear and tear.

Growth Projects

The rail industry is not only spending a lot of money to modernize and improve its existing structure but it’s also spending billions of dollars a year to grow its current network. Expansion projects and the re-working of existing rail lines are key opportunities for growth and provide operational efficiencies.

One major project is called the Chicago Region Environmental and Transportation Efficiency Program (CREATE). This is a major collaboration between the City of Chicago, the State of Illinois, Metra, Amtrak, the U.S. Department of Transportation, and the major railroads. The project is expected to be completed in 2030 and cost $3 billion. The project will involve the construction of new overpasses/underpasses, upgrades to tracks, switches, signals, and improvements to crossing safety. The main goals are to improve service, reduce congestion, promote economic development, and improve the environment. Chicago handles about one quarter of North America’s freight rail traffic. Chicago has become a major bottleneck as the infrastructure was not built for the kind of volume experienced today. In the next 30 years, freight rail traffic is expected to double. Without this project, $1-$7 billion could be lost in economic production on an annual basis.

The Crescent Corridor project is a partnership between Norfolk Southern and 13 states. It’s a rail infrastructure project stretching from the Gulf Coast to the East Coast, which is expected to be completed by 2020 and cost around $2.5 billion. Norfolk Southern will make changes that will enable the line to add more freight. These enhancements include the building of new track, straightening curves, adding signals, and building and expanding terminals. The project is expected to create 73,000 jobs by 2030, and is expected to save 170 million gallons of fuel while taking 1.3 million trucks off the highways annually.

Union Pacific is expected to spend about $400 million on a project to build a new rail facility in Santa Teresa, New Mexico. The project is expected to be completed by 2015. When the project is complete, the facility will include 200 miles of track and 26 buildings for yard operations including intermodal and fueling capabilities. This project should enhance the movement of goods throughout the southwestern United States and position Southern New Mexico as a critical component of the “Sunset Route”, as shown in the map in Exhibit 4 .

Investment in new and existing infrastructure and dedication to innovative technology are some of the most important ways that the railroad industry has been able to improve productivity and enhance profitability. As the economy expands and the demand for the cost efficient transportation of goods increases, we expect the rails to continue to find ways to respond to network demands while joining the vast global transportation network.

 Written by:

Michael J. Ashley
Vice President, Corporate Credit

After Strong Performance in the First Quarter, Corporate Bond Spreads are Widening in April Due to European and U.S. Growth Concerns

The Corporate bond market posted 34 basis points (bps) of positive excess returns vs. U.S. Treasuries in March, generated mainly by the Finance sector as well as short-to-intermediate Industrial and Utility credits. At month-end, Spain released its budget and shortly thereafter, the disappointing U.S. jobs data was released. Hence, spreads have widened this month, Finance and European credits bearing the brunt of the widening. As evidenced by the reaction from both the equity and bond markets, Europe remains on investors’ minds as well as the vigor of U.S. growth.

European Headlines Will Persist

We detailed the challenges Spain faces fiscally and politically in our recent white paper (“AAM Thought Leadership: The Pain in Spain Falls Mainly on the…” ). We believe that Spain will likely need to request formal support from the Troika sometime during 2012 or 2013 (and potentially much sooner). The increase in TARGET2 balances (bank borrowings from the Eurosystem) for Italy as well as Spain is also concerning. This, in addition to the debt issuance needs of Portugal in late summer or early fall 2012, Italy’s recent backsliding on its budget deficit, the French election, among others, are likely to keep spreads volatile in the near term. The consideration being given to direct capitalization of Spanish banks by the European Fiscal Stability Fund (EFSF) is encouraging. We have long believed that Europe needs its own form of TARP (Troubled Asset Relief Program).

The Micro Picture is More Favorable Albeit Tepid

Earnings estimates for the first quarter of 2012 were revised down over the second half of 2011, and most companies are poised to beat in our opinion. Our credit and industry level cues point to a domestic economy that is on track for low single digit growth in 2012. The level and trend of commodity based railroad carloads is one example of improving economic activity (Exhibit 2) where carloads continue to trend above 2011 levels. Additionally, initial bank results have been modestly positive. Headline numbers were highlighted by strong capital markets results, but a deeper look shows modest loan growth to both companies and individuals, including strong mortgage lending results. Asset quality continued its improving trend and organic capital generation was also a positive highlight despite increased dividends and share buy-backs by most banks under coverage. 

With profits recovering and cash coffers full, companies are increasing dividends and share repurchases. While this is not welcome from a bondholder perspective, it possibly does point to a turn in the cycle and increasing management confidence in the political and economic outlook domestically and abroad. We would have more confidence if we saw companies investing in their businesses by hiring, spending more on research and development (R&D) and/or making other investments. (Exhibit 3)

Invest Cautiously to Maximize Risk Adjusted Income

Our base case is that corporate market spread volatility will be high but not exceed the level in 2011 (Exhibit 4), since investors and companies have had time to contemplate and reposition, spreads have widened especially for sectors directly exposed to the crisis, company balance sheets remain strong, liquidity has improved with companies accessing the markets (high yield, investment grade, domestic and European) this quarter, and the U.S. 10-year Treasury yield is 141 basis points lower than one year ago or 1.95%. That said, we recognize all corporate bond spreads will widen dramatically if tail risk manifests itself. Regardless, portfolios must be managed to compensate investors for expected volatility. We entered the year positioned with bonds that we believed would be less volatile due to favorable structures, technicals, or fundamentals. As shown in Exhibit 5, technicals alone are significant drivers of volatility in this more illiquid market environment, which we believe is not changing in the near-to-intermediate term.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

In this “white paper,” we contemplate Spain’s fiscal profile, its banking system and the support mechanisms available to address a funding shortfall in the event Spain loses access to the capital markets. We will conclude with a credit view on the impact on corporate bond markets should Spain be forced to turn to the European Union (EU), the European Central Bank (ECB), or the International Monetary Fund (IMF) for further support.  

Sizing the Problem  

Risking a much overused cliché, Spain really is “too big to fail” within the European context. With a GDP of €1.07 trillion, Spain is the Eurozone’s fourth largest economy representing 11% of consolidated €9.4 trillion GDP (Greece, by contrast, accounted for 3%). 

The inherent imbalances in the Euro system (common monetary policy/divergent fiscal policies) resulted in a real estate bubble in Spain over the past decade and a material increase in leverage at the government level, in the private sector and by the households. As a result, Spain finds itself with unsustainable (and growing) government debt levels, a banking sector that is struggling to de-lever in the face of a burst real estate bubble and an economy that is expected to slip again into recession in 2012.  

Spain’s Fiscal Profile  

The economic recession that followed the global financial crisis in 2008 accelerated the fiscal imbalances within Spain. A persistent structural budget deficit was aggravated by the recession (Exhibit 2), resulting in a rapid growth of Spain’s debt/GDP measure (Exhibit 3).  

While successive Spanish governments have committed to reducing the structural budget deficit through austerity measures, the slowing economy has frustrated these efforts. As a result, the budget deficit which stood at -9.3% in fiscal year 2010 missed its fiscal year 2011 target of -6.0% by a material margin, coming in at -8.5%. The newly elected government reignited fears about fiscal sustainability in February 2012 when it announced Spain would miss its fiscal year 2012 deficit target of -4.4%. And investors are generally skeptical about the revised target of -5.3%, which appears politically expedient, but economically difficult to achieve (Exhibit 4).  

Impediments to Growth  

While Spain’s current debt/GDP level actually compares favorably to most of its Eurozone peers, the country’s lack of economic growth, as well as the potential need to support its banking system (more on this below) are the primary drivers of the capital market concerns that threaten its ability to refinance its substantial external debts. While a resumption of economic growth will be key to ultimately reversing the deterioration in Spain’s fiscal profile, there are a number of factors impeding such growth.  

The biggest challenge is Spain’s inflexible labor system, which makes it very difficult for employers to adjust their labor force through lay-offs. The result has been persistently high unemployment, which spiked as a result of the 2009/2010 recession, but made companies reluctant to hire new employees as the country emerged from recession in 2011 (Exhibit 6). Unemployment was also aggravated by the high proportion of the population involved in the Spanish construction industry, which has collapsed following the bursting of the country’s real estate bubble. The imposition of successive austerity programs in an effort to close the budget deficit has further hurt employment in the public sector. As a result, Spain has the highest unemployment rate in the Eurozone at 23%, and unemployment among those under 30 is nearly 45% (Exhibit 5).  

The Spanish Banking System  

Beyond the impact on employment levels, the collapse of the real estate bubble has left the Spanish banks with an outsized real estate loan book that is suffering from deteriorating asset quality due to the factors discussed above (recession/high unemployment). Just to size the problem, the Spanish banking system had a total loan book of €1.8 trillion (equivalent to 180% of GDP) at year end 2012 and non-performing loans (NPL) were €136 billion (7.6% of loans). Against this, the Spanish banking system has loan loss provisions (LLP) of €108 billion and tangible common equity of €203 billion.  

If the economy slips back into recession in 2012, NPLs across all loan classes are likely to grow, but real estate is of particular concern. While the Spanish real estate bubble burst in 2008, real estate prices have fallen far less (down approximately 20-25%) than in other countries with collapsed real estate bubbles (i.e., United States, Ireland). Residential mortgage loans stood at €657 billion (2.8% NPL) while corporate real estate (commercial real estate/real estate development companies) stood at €397 billion (20.1% NPL). Estimates vary, but under the assumption that asset quality continues to worsen in the face of renewed recession and continued decrease in real estate prices, additional provisions required by the banks could range from €100 to €200 billion. With a pre-provision profit generating capacity estimated in the €40-45 billion range, even an increase of provision expense of €100 billion would begin to erode the capital of the banking system. As shown in Exhibit 7, Spanish banks already have a high proportion of NPL to LLP+ Tangible Common Equity (informally known as the Texas Ratio – as it approaches 100% the likelihood of bank failure also approaches 100%).  

Regulators have pushed for a consolidation within the banking sector, with stronger banks absorbing weaker banks. But, as we demonstrated with the consolidated bank system ratios above (and the experience of Japan during the ‘90s), such a strategy can only be taken so far before it cripples the entire system. Spanish regulators have attempted to pre-empt this issue by changing bank provisioning standards to require a provision build of approximately €100 billion within the banking system. However, given the limited capacity of the Spanish banks to generate capital organically or through private market capital increases, it is likely that a large portion of this increase will have to come from public sources. To this end, the Spanish government has established the Fund for Orderly Bank Restructuring (FROB) which can provide public capital injections for struggling banks and has injected €14 billion in public capital to date. 

However, given the persistent budget deficit and growing debt/GDP ratio, Spain can ill afford to inject a further €50-150 billion in capital. With outstanding sovereign debt of €735 billion and a debt/GDP ratio that officially stood at 68% at year end 2011, every additional €50 billion of capital injected into the bank sector raises the ratio by five percentage points (and this is before contemplating the budget deficit and GDP contraction).  

Spain’s Dual Liquidity Crunches (Squeezes/Crises?)  

As a result of its fiscal and banking challenges, Spain faces dual liquidity squeezes on its access to sovereign funding in the bond market and bank funding in the deposit and wholesale markets.  

Within the sovereign debt markets, this is reflected in Spain’s debt costs, with yields on existing debt rising above a 6% yield, reflecting sovereign investors’ unease over Spain’s fiscal sustainability. Yields substantially above the country’s own GDP growth rate raise the question of long-term sustainability of the country’s debt load and aggravates the growing debt/GDP ratio. At the extreme, the rising yields reflect growing unwillingness of sovereign debt investors to support Spanish debt. With issuance needs of approximately €185 billion for 2012 (including €100 billion of short-term bills that must be refinanced), the potential that investors decline to purchase Spanish sovereign issuance raises the real prospect of a sovereign default.  

The Spanish banking system has already effectively lost access to the wholesale funding markets and investors have pulled away from Spanish bank bonds on fears about the system’s solvency in the face of rising credit costs. At the same time, retail and institutional deposits have been migrating from the Spanish banking system and into banking systems viewed as more stable (Germany/Netherlands/France). A funding crisis has been averted only through reliance on the European Central Bank’s (ECB) emergency lending programs. However, ECB liquidity is only a temporary solution, and its requirement for collateral against funding advanced is rapidly encumbering Spanish bank balance sheets (and effectively subordinating unsecured bond holders, thus further reducing the likelihood that they resume funding the banks). Furthermore, while ECB liquidity stems concerns about an immediate bank failure, it does nothing to address market concerns about the solvency of the Spanish banking system.  

Crisis Fighting Options for Spain  

While Spain would ideally prefer to address its sovereign funding and bank funding/solvency issues internally, it already appears that this option is not available. At a minimum, the need for the banking system to access ECB liquidity is a tacit admission that Spain is unable to provide support. There appear to be two options that Spain and the EU can utilize to tackle the current crisis:  

• European Central Bank Liquidity – As noted above, the Spanish banking system is already accessing ECB emergency liquidity through the Longer-term Refinancing Operation (LTRO), through which the ECB provides unlimited three year loans to banks in return for collateral (paradoxically, the LTRO liquidity provided to the banks has largely been reinvested in Spanish sovereign debt, temporarily lowering Spanish sovereign yields, although this effect is temporary). Additionally, the ECB has provided indirect liquidity support to struggling Eurozone sovereigns through its Security Market Purchase (SMP) program which purchases sovereign debt in the secondary market with the goal of reducing yields. While the ECB has theoretically unlimited capacity to provide liquidity at both the banking and sovereign levels, practically these measures amount to a stopgap. Regarding bank funding, we have already noted that the LTRO funding for banks is limited by the stock of eligible collateral, and cannot provide capital infusions to address solvency concerns. And on the sovereign funding level, SMP has been highly controversial in the EU, with some nations (especially Germany) opposing it as a backdoor quantitative easing that could ultimately stoke inflation. Because the SMP is not a formal support program that imposes fiscal conditions on borrowers, but rather an open market program, it is a temporary liquidity stopgap, rather than a formal tool for addressing fiscal imbalances. To this end, the ECB Board has explicitly warned that the SMP should not be viewed as unlimited, and that addressing the fiscal challenges of the Eurozone must be undertaken at the governmental/fiscal level rather than being tackled by the monetary authority (ECB)
•   EU Crisis Programs – Since the advent of the Eurozone crisis in mid-2010, the EU has established two separate funds to aid struggling sovereigns as they undertake fiscal consolidation. The European Fiscal Stability Fund (EFSF) was intended as a temporary €440 billion fund. The European Stability Mechanism (ESM) was established by treaty in 2011 as a €500 billion permanent replacement to the EFSF. In an attempt to add credibility in the face of multiple sovereign crises during 2011, the EU agreed to accelerate the advent of the ESM to July 2012 (although the ESM has yet to be ratified by all EU members). To date, three countries (Greece, Ireland and Portugal) have entered a fiscal consolidation plan with support from the EFSF/ESM programs (with varying success). The use of EFSF/ESM programs to aid Spain through its sovereign and banking crises has several pros including: (a) flexibility to fund a defined program of fiscal consolidation, and (b) the ability to provide direct recapitalization of the Spanish banking sector, thus taking pressure off the sovereign. However, there are also several hurdles to such an approach. First, it would require an explicit Spanish request for assistance, and any program Spain entered into would require it to surrender a degree of sovereignty to the EU administrators of the program (and the new government has already expressed reservations about encroachment on Spanish sovereignty). More practically, the EFSF/ESM programs are “committed” but unfunded, and would require substantial issuance of bonds jointly and severally guaranteed by all EU members. This raises questions both of the market’s capacity for absorbing such funding needs (above and beyond what has already been committed to Greece/Ireland/Portugal). Furthermore, the creditworthiness of the EFSF/ESM relies entirely on the credit of the underlying members, of which Spain is one of the larger members, raising questions about the creditworthiness of the EU as a whole. Ultimately, the credibility of the EFSF/ESM rests in large part on the willingness and capacity of the EU’s strongest member, Germany, to support weaker EU members. This appears ultimately to be political rather than financial question, and subject to domestic political and economic considerations. We believe Germany will ultimately decide that it is in its own best interest to support its fellow EU members, but this outcome is by no means a certainty. 

Conclusion: Expectations and Credit Implications  

We believe that Spain likely will need to request formal support from the EU/ECB/IMF sometime during 2012 or 2013 (and potentially much sooner). The likely form of support is via a negotiated program utilizing the EFSF/ESM (rather than continued ad hoc support through the ECB). The most likely driver of the request in the near-term would be a continued rise in sovereign funding costs beyond the point of sustainability. However, even in the event that funding pressures ease, Spain is likely to face increased pressure to enter a formal program, either from the ECB which is unlikely to provide permanent open ended funding for its banking system, or from the EU if it slips behind schedule on its fiscal consolidation program (which we believe is likely).  

The resolution of Spain’s fiscal and banking challenges has credit implications for both Spain and the broader EU. Failure to address Spain’s economy (and all of the struggling Euro area’s economies) in an orderly manner would ultimately threaten the existence of single currency, and could result in serious disruption to the European economy and financial system. We believe that the most likely outcome is a collective agreement by EU members to preserve the currency while working through fiscal consolidation of the weaker economies. Ultimately, this likely results in a greater degree of fiscal integration within the EU (a necessity if the single currency is to survive) and we do NOT rule out the possibility of further sovereign restructurings (in the mold of Greece) although that is not our default expectation with Spain (given their relatively stronger fiscal profile). However, the challenge of achieving political consensus among the seventeen Euro currency members and the twenty seven European Union members has already made itself evident in the manner in which the EU has stumbled from crisis to crisis. We expect this approach to continue, and as such, believe that the investment grade corporate bond markets will be subject to recurring episodes of volatility surrounding fiscal/political developments in the Eurozone.  

Consequently, we remain very cautious on corporate issuers with direct exposure to the weaker EU sovereigns (Telefonica/Iberdrola) and have also reduced our exposure to all European banks (given the interconnectedness of European bank funding of EU sovereign debt issuance). We are also cognizant of the impact of EU credit volatility on the U.S. money center bank sector, although fundamentally the U.S. banks have very manageable direct exposures to Europe.　 

Written by:  

N. Sebastian Bacchus, CFA
Vice President, Corporate Credit　 

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.  

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. 

Supply during the first quarter was up sharply from last year, primarily as a result of refinancing/refunding of currently-callable structures. Overall supply increased by 63.5% to a total of $78.2 billion, with 47% of this amount directly related to refinancings. That’s an increase of 159% over first quarter 2011 refinancings and a 74% increase over the average refinancing volume for the period 2006 to 2010. The refinancings have been driven in large part by the near-record low interest rate environment and the need for municipalities to garner budgetary savings wherever they can find them.

However, first quarter new money financing of $26.4 billion remains at anemic levels, with a decrease of 3% relative to 2011. When compared to the 5-year average for the period from 2006 to 2010, the percentage decline is substantial with a decrease of 51%. These numbers suggest that most of the austerity measures at the state and local level are still in force and portends a modest new-money issuance cycle for 2012.

In the near term, technicals should gradually improve. After the tax-filing season has passed in mid-April, the market begins to move closer to another upswing in heavier reinvestment flows in May, June and July. Additionally, with most of the refinancing supply targeting currently-callable structures, a large number of investors will receive the proceeds of these calls and will need to redeploy them in the market.

Based on the positive trend for demand flows, the outlook for the municipal market is for relative performance to be positive over the next quarter. But as in the first quarter, the market should continue to experience significant swings in relative valuation levels. Current 10-year tax-adjusted municipal yield spreads versus Treasuries are at 104 bps, which is substantially higher than the 54 bps spread that existed on January 19th. Current spreads also remain well-below the 173 bps spread that existed on October 7, 2011. Consequently, tax-exempt spread levels look to be fairly valued today. However, with approximately 50% of the market’s new-issue supply made up of rate-sensitive refinancings, the market could experience very volatile performance on either a sharp increase in supply or any substantial spike in yields. In the latter case, significant yield increases could reduce the potential savings of refinancings and drastically reduce the pace of supply during 2012, resulting in tax-adjusted spreads tightening dramatically from current levels. In either case, we will continue to closely monitor supply/demand dynamics over the coming quarter and look to trade on imbalance-related opportunities as they occur.

Written by:
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

AAM’s President, John L. Schaefer, commented on the relationship, “We are very excited to add Muzinich’s high yield capabilities to our platform of creative investment solutions for insurance companies. We performed a thorough due diligence review to identify an appropriate partner, and believe that Muzinich’s strong record of risk-adjusted performance is an ideal fit with the income needs and risk tolerances of the insurance industry.”

Justin Muzinich, Vice Chairman of Muzinich & Co. added that “collaborating with AAM will provide a valuable partnership for our firm as we continue our expansion into the US institutional marketplace. We are thrilled to join forces with AAM as they expand their suite of product offerings to the insurance industry.” 

About AAM: AAM (www.aamcompany.com) is a SEC registered investment advisor specializing in the management of insurance company portfolios. AAM offers comprehensive investment management that incorporates an array of value added services, including Schedule D Investment Accounting, Dynamic Tax Analysis and Dynamic Asset/Liability Modeling. AAM’s team of senior managers averages 22 years of investment industry experience with a portfolio management team averaging 17 years of experience. As of December 31, 2011, AAM manages over US$15.8 billion in assets for 98 insurance company clients, across all segments of the industry. 

About Muzinich: Muzinich & Co. (www.muzinich.com) is an SEC registered, global institutional asset manager headquartered in New York with offices in London, Cologne and Paris. With a 20 year track record and a credit team that is among the most experienced in the industry, their investment offerings include high yield (traditional and short duration), bank loans, long/short credit hedge funds and corporate plus (cross over strategy). As of February 29, 2011, the firm has over $16 billion in assets under management and 53 employees.

The Positive Role of the LTRO

Risk assets have rallied in 2012, fueled by European Central Bank (ECB) stimulus via the Longer Term Refinancing Operation (LTRO). The liquidity provided by the LTRO gives banks and sovereigns more time to deleverage their balance sheets, avoiding a liquidity crunch and softening the impact to the economies of such deleveraging. Importantly, the increased liquidity has reduced the risk of a bank failure in the near term, decreasing the likelihood of a sovereign bailout of such banks, thereby decreasing sovereign risk. In effect, the LTRO has reversed the negative feedback loop in the second half of 2011.

Certainly, tail risk that existed prior to the LTRO has fallen. And, as the costs of a Greek bankruptcy and departure from the European Union are increasingly externalized to the European core, the likelihood that the core allows Greece to default decreases. Accordingly, the risk premium in Investment Grade credit associated with Europe has fallen (we wrote in our 2012 Outlook for the January 2012 AAM Corporate Credit View that it was approximately 60 basis points (bps) or one third of the market Option Adjusted Spread at that time). Corporate spreads year-to-date as of February 29, 2012 have tightened 53 bps, with Finance outperforming (92 bps tighter) Utilities (26 bps tighter) and Industrials (37 bps tighter). Spreads have tightened to the mean over the last year (Exhibit 1).

Sovereign Risk Has Not Disappeared

Liquidity aside, risk remains in Europe over the next 12 to 18 months mainly due to the likelihood of weaker than expected economic growth, resulting in missed deficit targets, etc, possibly creating another funding crisis for the sovereigns of mainly Spain and Italy, igniting systemic fears. Spain recently announced that it will miss its deficit target and the market took it in stride. We are aware that the market’s expectation is for growth in the Eurozone to improve after a weak first quarter in 2012; therefore, we believe that the second half 2012 will be the appropriate time to test the market’s response. The unknown is how growth will be affected by the austerity measures and resulting political action. Eurozone leaders have strongly indicated that they will continue to provide financial support as long as a funding country remains committed.

Secondly, Ireland and Portugal debt restructuring fears are likely to re-emerge. Portugal will need to access the debt markets in the second half 2012 to pre-fund its September 23, 2013 maturity (IMF (International Monetary Fund) involvement requires funding assurance twelve months ahead). Eurozone leaders have been adamant that PSI (Private Sector Involvement) is unique to Greece and should not be expected for other countries, and willing to be patient as long as Portugal remains committed. This is something the market will likely test especially if Portugal’s progress is underwhelming. That said, we understand the incentives Eurozone leaders have to keep this contained, mainly the fear that would spread again to Spain and Italy.

In summary, we acknowledge the reduced sovereign and thus systemic risk in the near term, but remain concerned about this risk in the intermediate term. Economic growth and greater fiscal integration is critical for this risk to be contained. While economic growth in emerging markets and the U.S. may prove beneficial for European exports and ultimately growth, the Middle East tensions and the rising price of oil is a concern for Europe’s progress as well as the rest of the world.

Higher Risk Corporate Securities Have Outperformed

In the Investment Grade Corporate market, we have seen the risk premium for European credits fall this year, as investors take advantage of the near term respite from sovereign related volatility. Similarly, lower rated credits have outperformed as well as Financials (Exhibits 2-5). Investors are not looking to increase yield by moving out the curve, fearful of a rise in Treasuries. With spreads of intermediate maturities falling more than long, credit curves remain fairly steep. Broker/dealer inventories remain very low; therefore, it is not surprising that new issue Corporate deals have been in high demand. New issue concessions have fallen to levels witnessed in bullish market environments, and deals are greatly oversubscribed.

AAM’s View of the Market Remains Cautiously Optimistic

Over two thirds of companies have reported financial results, and while the fourth quarter was lackluster as expected, management forecasts (albeit lighter than usual on details) were constructive and comments about first quarter have been quite positive. For instance, capital expenditures forecasted for 2012 have increased 5% over the last two months for virtually all industries, especially those that are most meaningful (Energy, Metals & Mining, Telecom).

We remain prepared for another year of heightened market volatility given the risks and the very low rates of economic growth forecasted for countries around the globe. The technical environment is modestly negative right now after a strong rally and the expectation for a heavy new issue month in March. Corporate securities have performed well so far (Exhibits 6 and 7), reaching the tighter end of our “fair value” range. In particular, we have seen outperformance from Insurance, Energy – Refining and Oil Services, Pipelines, Media and Finance as well as subordinated bank securities.

Our focus year-to-date has remained one of defensive optimism. We are avoiding Europe, low quality investment grade companies, and companies that will struggle to grow in the near term. As well, we are neutral on banks, investing in those that are higher quality with a domestic focus, while avoiding brokers and finance companies (excluding GE). We are very mindful of expected volatility, investing in securities we believe will produce the highest risk adjusted returns.

Written by:

Elizabeth Henderson, CFA�
Director of Corporate Credit

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Overview

Performance in 2011 departed from our outlook of positive excess returns largely due to the heightened systemic risk emanating from Europe, causing a flight to quality rally. In 2012, we expect spread volatility will continue, as Europe remains in the headlines, affecting economies in Asia and the U.S. Although not what we expect, a fracturing of the European Union (EU) is certainly a possibility with some economists using it as their base case. We anticipate investor concern will reignite, stemming from weaker than expected economic growth, debt restructurings (Greece, Ireland, Portugal) and resistance to more austerity.

Our base case is that the EU remains intact after debt monetization by the European Central Bank (ECB) due to the high direct and indirect costs to Germany and France of a departure; however, we do not believe this intervention will be immediate. Therefore, we are expecting spread volatility to be similar or higher than 2011. We recognize company fundamentals are very strong and the U.S. economy continues to grow albeit at a low rate. That said, the downside risk (which is largely political) and overall vulnerability of economic growth coupled with high sovereign debt levels tempers our optimism. We are selectively positive on investment grade Corporate credit and are avoiding Europe, growth challenged sectors and low quality credits. Our view is the market is fairly valued, and risk adjusted income is particularly attractive in higher quality BBB cyclical Industrials, pipelines, domestic banks, and REITs. Although fundamentals may have peaked last year, we believe the uncertainty associated with Europe will cause most management teams to remain cautious when deploying capital and committed to a strong and liquid balance sheet.

From a technical standpoint, our views are mixed. Although we expect a healthy new issue calendar and dealer inventories of corporate bonds are low, investors have increased their overweight to U.S. corporate credit and the cost of liquidity associated with the Volcker Rule could be significant. We are less bearish on long duration Corporate bonds than this time last year due to the spread widening and slight steepening of the credit curves (10 year to 30 year spread basis widened by approximately 10 basis points), but we continue to prefer the intermediate part of the curve due to the anticipated market volatility and current spread levels.

The Corporate Market Underperformed in 2011

Despite the domestic economy and company fundamentals performing as we had expected in 2011, heightened systemic and political risk resulted in a flight to quality with 5+ year Treasury yields falling over 100 bps, and investment grade credit spreads widening 78 bps. Financials underperformed more defensive Industrial and Utility sectors, and longer duration securities performed exceptionally badly, -846 bps of excess return vs. the market’s -367 bps (defined by Barclays Capital U.S. Corporate Index). The differential between BBB and A-rated Industrial credits widened from 74 bps at year-end 2010 to 121 bps, which is wide of its 98 bps historic mean and reflective of the differential in mid-2009. Generally, European financial and infrastructure credits underperformed domestic peers, exemplified by the spread differential (“basis”) between European and domestic banks, widening from 104 to 143 bps per the Credit Suisse LUCI Index. As shown in Exhibit 1, performance did not rest on the macro call alone. The Metals and Mining industry is a good example of credit selection. While Southern Peru Copper, Anglogold (shown in Exhibit 1), and Commercial Metals (which was downgraded to high yield, falling out of the investment grade market) underperformed significantly, BHP Billiton and Rio Tinto outperformed the market.

Spreads are Wide But Volatility is High

Spread volatility increased significantly in 2012, 40 bps vs. 13 bps in 2010. That said, 38 bps is the average over the last decade. As shown in Exhibit 2, the market is expecting the current rate of volatility to continue. While this is our base case, we believe there is a greater probability that volatility will be higher in 2012. Fiscal problems in Europe and the U.S. remain unsolved while GDP growth rate expectations are fairly dismal, and emerging markets are cooling. Positively, if the year is benign, we could see systemic risk premiums decrease a considerable amount (one third of the market OAS) especially in Financials.

One would assume in an environment of rising volatility, especially tail risk, yields would increase to compensate investors. That did not happen for U.S. credit. The very strong fundamentals of domestically domiciled companies and the containment of risk in Europe kept defaults very low in the U.S. (1.5%) and recoveries better than average, yielding a very low loss rate (0.6%). Defaults are expected to increase in 2012 in the U.S. (4.8%) albeit remaining lower than the historic average. Europe should see another year of higher defaults, remaining very vulnerable to bank deleveraging since the banks have provided the majority of credit vs. the public capital markets in the U.S. Moreover, European firms are more leveraged and face lower growth prospects. Therefore, it will be evident in 2012 if the two markets can decouple as many market pundits are expecting. We believe it is very difficult for significant deleveraging to occur and not affect other economies world wide. China, for instance, was a primary beneficiary of the bank expansion in the European Union and the United Kingdom.

Supply of Spread Product is Expected to Decrease (Again) in 2012

The new issue market for investment grade corporate issuers was active in 2011, but lower than 2010 with gross issuance $630 billion vs. $659 billion. Financial issuance decreased in 2011 due to deleveraging that continued in the U.S. and the buyer’s strike that occurred for European financials in the second half of the year. Industrial issuance was up in 2011, generally related to increased share buyback and merger and acquisition (M&A) activity as well as the continued pre-funding of maturities. Despite the high level of systemic risk and volatility, M&A was up in 2011 ($2.3 trillion globally vs. $2.2 trillion in 2010), and acquisition premiums remained in the low-mid 20% range per Bloomberg. Domestically, corporate fundamentals, liquidity in particular, are very strong, and with low interest rates and weak growth, heightened M&A activity is to be expected.

We expect 2012 new issuance of investment grade corporate bonds to be $545 billion gross, $250 billion net of redemptions, slightly less than 2011 levels. Since coupon payments for investment grade corporate securities are expected to be $240 billion in 2012, and net supply is expected to be negative for all other spread sectors (Exhibit 3), technicals should be supportive in 2012. We have witnessed increased issuance from European industrial issuers in the high yield market this month. Although less likely in the investment grade market, it could provide an upside to our estimate.

In addition to falling new issuance, secondary supply has continued to contract with primary dealer corporate bond inventory falling to levels not seen since 2003 (Exhibit 4). We wrote about this dynamic in early 2011, explaining the regulatory and structural changes. Market volatility increased mid-year, forcing dealers to reduce positions further. JPMorgan estimates that dealer inventory is now less than 1% of the investment grade market vs. the peak in 2007 of 10%. The reduction of liquidity is a real challenge for large asset managers and insurance companies. Importantly, for asset managers who are able to access both markets, a trader must consider the following when buying or selling bonds: liquidity, amortization of high dollar prices, and curve placement (due to the very steep Treasury curve) to name a few. The uncertainty relating to the Volcker Rule is material, reducing liquidity and widening bid-ask spreads.

Sector Outlooks

Banks – Fair (Prefer U.S., Avoid Europe)

The Bank sector is left facing unresolved macro-political headwinds in 2012. The dual uncertainties of political/regulatory risk in the United States and sovereign crisis in Europe completely overshadow a continued strengthening of underlying fundamentals. These persistent macro-political risks, as well as our more cautious outlook for economic growth in 2012, have led us to lower our sector view to “Fair” from “Attractive.” We continue to prefer strong domestic banks and avoid those in Europe and Asia. Furthermore, while the regulatory reforms enacted over the past two years have the potential to transform the sector into a much more stable, utility-like sector, the high-beta characterization of the sector was affirmed in 2011 and should be assumed to continue over the intermediate-term.

Real Estate Investment Trusts (REITs) – Attractive

This sector is largely domestic, benefitting from the economic recovery, low interest rates and lack of new construction. We have preferred apartment and central business district (CBD) office REITs vs. retail, healthcare, and warehouse. While economic uncertainty in the second half of 2011 has weighed on spreads, fundamentals for the sector are much stronger than they were heading into 2008. REITs have materially improved liquidity, balance sheet leverage, occupancy and net operating income over the past three years, making the sector more attractive on a stand alone basis, and leaving public REITs much better positioned vs. private real estate owners as new properties become available. While heavy recurring funding needs are an ever present concern for the sector, most REIT issuers have successfully entered/renewed credit lines on favorable terms over the past six months, and liquidity availability is reasonable relative to maturity and operating needs over the next twelve months. We believe this sector offers attractive value especially versus lower yielding CMBS and BBB cyclical Industrials.

Insurance – Fair

Risks for life insurance companies increased last year, as equity volatility and systemic risk increased and the prospect for rising yields in the near term dimmed. Operationally, property and casualty companies performed worse than expected given the higher level of claims. This should normalize, increasing the prospect for improved pricing. Fundamentally, we continue to prefer the health insurance sector. Notwithstanding the new legislation, this sector is highly profitable with structural benefits. In this environment, we prefer only the highest quality companies and senior positions in the capital structure.

Basic Industries – Fair (Prefer strong BBBs)

Chemicals – This sector has reduced its cyclicality by becoming more of a specialty products industry where pricing power is easier to maintain. It benefits from its limited exposure to Europe and growth from the U.S., Asia and Latin America. This coupled with the benefit of lower natural gas prices for North American chemicals allowed us to become more positive on the industry. The sector outperformed last year, and we view it as fairly valued with a risk adjusted income profile similar to the broad Industrial Index.

Metals/Mining – As mentioned earlier in the article, this sector is a combination of diversified and pure play companies; therefore, commodity price forecasts and geographic exposures (including an assessment of political risk) are important factors in the analysis. Metals prices were very high coming into 2011, and as they dropped, pure play companies underperformed. We prefer the diversified operators because of this volatility, and the reduced probability of balance sheet damaging, transformational acquisitions. Moreover, with China comprising approximately 40% of the demand for metals, its continued growth is critical. Spreads widened in 2011, taking into account the concerns about slowing economic growth especially in China. We expect this sector to remain volatile, preferring the higher quality, diversified operators.

Capital Goods (Avoid credits reliant on government funding)

Aerospace/Defense – This sector underperformed last year, as risk premiums were assigned to reflect the pressure on revenues due to the defense spending cuts forecasted which will impact credit metrics. We expect lower top line growth in addition to compressing margins from more competitive pricing to challenge management teams and increase event risk and shareholder friendly actions. Despite the spread widening, we remain negative on this sector, expecting downward rating migration.

Construction Machinery and Diversified Manufacturing – U.S. manufacturing remains solid as reflected by indications of expansion through favorable PMI (Purchasing Manufacturing Index) readings since 2009. Companies in both sectors are highly rated, and diversified, geographically and by end market. Weakness in Europe should be offset by especially strong growth in mining and agriculture. We expect companies to finance acquisitions conservatively to preserve their ratings due to the necessity of funding working capital. Spreads are tight relative to other Industrials, but we believe this is appropriate given the fundamental outlook and positive technicals (little issuance).

Communications (Prefer Media and high quality Telecom)

Telecommunications – This sector continues to converge with media and telecom operators becoming more interdependent. We remain negatively disposed to the European telecom operators due to ratings risk, revenue and margin pressure from economic malaise and pro-consumer regulatory changes, and compressing free cash flow as EBITDA remains flat or decreases while dividends are high and capital spending needs to increase. In North America, especially the U.S., we believe consolidation is imperative as there are too many operators for a maturing industry. We are only investing in the largest and strongest due to these structural challenges that will pressure fundamentals for all.

Cable – In 2012, we expect the cable operators to get more aggressive with marketing their broadband service and new video interface technology to help them retain customers. That said, we believe if the consumer remains weak, voice revenues will remain under pressure and we could see DVR and other premium services get canceled as new technology is utilized (e.g., internet/video on demand instead of DVR). Capital spending is not going up, and continues to fall slowly which is good for equity holders. That said, companies are looking to consolidate the industry, so that will be a use of free cash flow and balance sheet capacity. Accordingly, we don’t expect the cable companies to reduce leverage in 2012 but to remain within ranges consistent with their rating categories. Given the high degree of operating leverage, we are largely avoiding the sector until this uncertainty is reduced.

Media/Entertainment – Benefitting from the Olympics and elections in 2012, advertising growth is expected to exceed GDP growth. Even though media is a cyclical sector due to its reliance on advertising and is exposed to the consumer via products, film entertainment (movies, DVDs) and theme parks, the fees they collect for content provide a revenue stream that should be resilient in a soft economy. The media sector benefits from its low capital intensity, and as we saw in the last recession, companies increase their financial flexibility by slowing share repurchases and M&A. They have improved their balance sheets over the last five years, operating with more discipline from a cost perspective. We believe media companies are best capitalized as BBB entities, requiring financial flexibility to invest in content creation. Spreads widened last year, and with the favorable forecast for advertising, we believe the sector should outperform other cyclical sectors this year. That said, companies differ in regards to exposure to various segments of the media market. We prefer those that produce content for television and are geographically diversified (skewed towards growth markets) with strong brands. We are avoiding companies with exposure to “old media” like textbooks, newspapers, and radio due to the technology and secular changes taking place.

Consumer Discretionary – Unattractive

Consumer Products – This is a mature sector with highly rated, diversified companies. Investors view it as one that is defensive despite the high level of event risk. Companies have benefited from growth in developing economies, and as global growth slows, we are concerned that it will result in leveraging M&A and/or shareholder friendly actions. That said, many companies rely on the commercial paper market to fund working capital, providing management with a real incentive to remain focused on their ratings (A1/P1 requires mid-A ratings at a minimum). Credits in this sector have very low yields, and we believe the risk adjusted income is not attractive relative to other investment alternatives.

Food/Beverage – Another defensive sector with similar characteristics and challenges as Consumer Products. Although commodity prices are down from their 2011 highs, we expect them to remain volatile and pressure margins if pricing gets challenged by consumers. We invest in companies that have recently entered into a large transaction, have significant advantages in terms of brand equity and/or are large and diversified with power over both suppliers and customers. Spreads are inside of the Industrial Index, appropriate in our view, but given our expectation of heightened event risk, we remain buyers on this new issuance.

Pharmaceuticals – This industry has performed very well with strong free cash flow and balance sheets. The patents associated with over $120 billion of branded drugs will expire between 2011-2015. This will pose a challenge for credits lacking diversification and/or a new product pipeline. Replacing lost revenue may result in another wave of M&A, which given already high credit ratings, will be largely debt financed. We prefer those companies that are diversified away from branded drugs and have solid pipelines. Similar to Food/Beverage, we take advantage of new issuance associated with large acquisitions, a trend we expect will continue in this sector.

Consumer Nondiscretionary – Fair

Retail – Holiday sales were better than expected, and luxury sales continued to be supported by a higher income demographic that that recovered more quickly from the recession. In 2012, we expect the consumer to remain cautious. Headlines and market volatility could cause the high end consumer to pause after an active year of spending in 2011. Lower commodity costs are likely to be offset from heavy promotion activity, resulting in very little margin expansion over last year. We expect companies that are underperforming (e.g., Lowe’s, Safeway) to seek shareholder return via debt financed activity. Our bias is to invest in the leaders in their respective categories (e.g., Walmart, Home Depot, Nordstrom’s, CVS), as low economic growth will be sufficient for these operators to perform well.

Energy – Fair to Attractive

Our more cautious outlook for economic growth and expectation for supply coming from Libya and shale offset by a reduction of supply from the Gulf of Mexico are main contributors to our outlook for oil of $85/barrel (WTI). Given this more pessimistic GDP outlook relative to 2011, we expect revenue and cash flow for Independents and Integrated energy companies to be weaker in 2012 versus 2011. Since our view differs from the market, we are taking advantage of the lack of differentiation among credits from a valuation perspective, investing in those we project will have positive free cash flow. Our more defensive bias causes us to prefer the Integrated sector, viewing valuations as attractive for large, diversified operators.

Future revenue and cash flow from the Oil Service sector is dependent on the capital spending of the Independents and Integrateds (collectively, the “Upstream”). Our less optimistic view of commodity prices results in a lower revenue projection for the industry. We are forecasting that Upstream capital spending will increase by 5% in 2012, rather than the 10-15% most are expecting. The reduction in revenue is manageable for most companies from a credit quality perspective. Therefore, despite our more pessimistic outlook, we are investing in the sector, preferring the higher quality oil field service companies (Schlumberger) and those focused on balance sheet improvement (Ensco). Spreads are compelling for the sector today versus Industrials due to the overhang related to the Gulf spill (affecting Transocean) and the lower credit quality nature of the sector (risk premiums increased for BBB Industrials especially deep cyclicals in 2011).

Technology – Unattractive

This sector has benefited from the economic recovery and investment from the business sector to increase productivity. We expect IT (Information Technology) spending to grow at a pace of 4% in 2012, slightly lower than 2011. Less discretionary items (storage, security, servers) should be in higher demand after spending on more discretionary items. We expect the trend of tablet replacement of PCs and data center outsourcing to continue, and for more companies to turn to the cloud for non-critical applications. The lack of risk adjusted income for low quality credits, keeps us investing defensively in this sector. We believe the downside risk is too great in challenged companies such as HP and Dell, preferring to invest in proven leaders with exposure to growth segments such as Oracle and IBM.

Transportation – Attractive: Rails

The structural challenges associated with the airline industry continue, as exemplified by American Airlines bankruptcy last year, causing us to avoid the Airline sector. However, we do like the Railroad sector and have a very favorable view of fundamentals. The industry has benefited from the diversity of product moved on the railcars and ability to gain market share from competition given strong service levels, attractive rates, and regulatory changes. After the recession, the rails were able to accommodate increased volumes without increasing expenses. Credit metrics are the strongest they have been in five years. We expect revenue growth to remain strong in 2012 (6% (4% from pricing, 2% from volume)) vs. the 9% we expect in 2011, as economic growth slows, fewer legacy contracts are renegotiated and price increases are more difficult to implement. Spreads have widened and are attractive relative to where they have traded over the last couple of years. Compelling valuation and our positive fundamental outlook makes this an attractive investment opportunity. 

Electric Utilities – Unattractive

We believe fundamentals for 2012 are neutral for electric utilities. We expect revenue and cash flow to be slightly weaker in the upcoming year based on flat demand, weaker electricity prices and slightly weaker margins. We expect demand to be flat based on domestic GDP growth of 1%-2% and flat weather related demand. Moreover, electricity prices are expected to be softer based on lower prices for both natural gas and Powder River Basin coal, the raw materials used to generate electricity. Margins are expected to be flat for regulated utilities, but slightly weaker for unregulated power producers due to weaker power prices and flat operating expenses. From a leverage perspective, we expect it to continue to creep higher as companies are unable to meaningfully reduce debt. Importantly, the regulatory environment is somewhat more certain than it was at this time last year.

Viewed as a defensive sector, the electric utility industry performed very well in 2011. Following the strong results of 2011, the Electric Utility OAS started 2012 at 89% of the Industrial OAS, which is substantially richer than its 1-yr and 5-yr averages, of 97% and 99%, respectively. This has been driven by strong demand for regulated operating company first mortgage paper, which tends to be rated in the single-A category. We prefer to take advantage of the discount currently offered by issuers at the holding company or unregulated operating company, and view the sector largely as unattractive on a risk adjusted basis. 

Pipelines – Fair to Attractive

We believe the fundamentals for the pipeline segment are positive. Volumes of oil, refined products, natural gas and natural gas shipments are largely determined by domestic GDP, which should increase slightly. Notably, volumes of natural gas liquids should probably increase faster than GDP growth given the heightened demand from the chemical sector. We believe another positive fundamental is the expanding number of resource basins, which will lead to greater size and cash flow generating capability. Thirdly, we expect balance sheets to continue to improve because many large projects are now generating cash flows after numerous quarters under construction. The one somewhat negative item affecting Master Limited Partnerships (MPLs) is heightened M&A risk. We could see more mergers as the pipeline companies recognize the benefits of diversifying their operations. Spreads widened in 2011, due to the sector’s reliance on external sources of financing. On a risk adjusted basis, expecting volatility to remain high in 2012, we believe spreads are Fair. That said, there are attractive opportunities in our preferred MLPs (Kinder Morgan Partners (KMP), Enterprise Products Partners (EPD)).

Summary of Sector Views

As shown in Exhibit 5, A rated Industrial credit spreads are slightly wider than one year ago with very little differentiation among sectors. Unlike last year when we had more pessimistic views on A rated retailers, consumer product companies, pharmaceuticals and media, after the spread widening that took place, valuations are more in line. We are more favorably disposed to the A rated Energy (Integrated) and domestic Telecom companies in the Industrial segment and continue to prefer domestic banks and Insurance companies within Finance.

Looking at Exhibits 5-7, especially Exhibit 7, it is evident that the basis between A and BBB rated Industrials widened due to the increased systemic risk and default risk in Europe. The spread widening in the Electric Utility, Telecom and Bank sectors was also due to the European credit spread widening. We noted the widening of the European and U.S. bank basis of 39 bps, and this was similar for European and domestic telecom (56 bps). Spreads have widened, especially for BBB issuers; therefore, the market is pricing in a level of uncertainty related to Europe and economic growth. Our expectation is for heightened volatility but with support from the ECB; therefore, we are investing defensively in the BBB rating category, preferring higher quality companies in cyclical sectors where the risk premiums are more significant. The same is true for Pipelines and REITs.

 Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

Michael Ashley
Vice President

N. Sebastian Bacchus, CFA
Vice President

Bob Bennett, CFA
Vice President

Patrick McGeever
Vice President

Hugh McCaffrey, CFA
Vice President

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Strong supply and demand technicals have largely been the driver of relative performance all year for the municipal market. Supply during 2011 totaled only $294.5 billion, which was the lowest level since 2001. Compared to 2010 levels, overall supply dropped 32%, while tax-exempt only supply saw a drop of 7% to a total of $262 billion. The large drop in overall issuance was a direct result of the expiration of the Build America Bond program and the massive austerity measures that municipalities undertook to close budget gaps. The spending-cut theme is likely to continue during 2012, which should keep municipal issuance at muted levels relative to issuance patterns over the last six years that saw average annual volume of $408 billion.

On the demand side, sponsorship for the sector during 2011 has largely been grounded in relative-value investors. These investors have been enamored with the generous nominal yields available in the municipal market that have been well north of comparable Treasuries across the yield curve. After 10-year municipal nominal spreads reached a peak of 56 bps on October 7, 2011, the buying momentum from relative-value investors, combined with retail demand from heavy December 1, 2011 reinvestment flows of coupon/calls/maturities, resulted in 10-year nominal yields tightening to -5 bps as of year-end. Demand has also benefited from the increase in inflows to tax-exempt mutual funds. Over the last five weeks through the period ending January 4, 2012, inflows have totaled $5.8 billion.

The increase in buying momentum across the retail and mutual fund segments can be attributed to the lack of credit events in the sector during the year. Entering 2011, a number of investors were worried about the wild predictions that defaults could reach $100 to $200 billion. However, defaults have largely been well contained. Through the end of the third quarter of 2011, defaults involving missed payments totaled about $2.6 billion. Additionally, budget-deficit related issues at the state level have also been addressed with spending cuts and tax increases. As a result of the revenue raising measures and economic growth, state revenues have seen increases over the last eight quarters and currently, only four states (WA, CA, NY, and MO) need to address new mid-year budget deficits. Overall, the credit profile for the sector is expected to continue to see slow progress as the economy improves, which should help maintain the buying momentum that the sector has experienced during 2011.

The near term outlook for the municipal sector is to expect relative valuations to remain at current levels through February. New issue supply should remain fairly quiet through January and February, while demand should remain in place as reinvestment flows from January 1, 2012 and February 1, 2012 coupons/calls/maturities enter the market. However, we anticipate that the recent spread-tightening trend has limited potential for further tightening over the next month. Consequently, we will be looking at opportunities to reduce our exposure to the tax-exempt market over the next several weeks. The strong technicals that are in place today are expected to reverse in March and April, when supply typically rises dramatically and reinvestment demand of coupon/calls/maturities falls substantially. The resulting drop in relative valuations and widening of tax-adjusted spreads should provide a compelling re-entry point for investment in the sector.

 Written by:

Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

NAIC

Structured Securities Rating Process

The NAIC designations for all securities that fall under the scope of SSAP No. 43R are calculated based on any of the following:The NAIC’s (PIMCO’s) RMBS Model

1. 1. The NAIC’s (PIMCO’s) RMBS Model
   2.  The NAIC’s (Blackrock’s) CMBS Model
   3. The Modified FE (Filing Exemption) Rule
   4.  A SVO (Securities Valuation Office) generated designation

In late 2010 (effective 2011), the NAIC expanded the scope of SSAP No. 43R to essentially include all securities issued from a trust or securities where the holders’ only recourse is to the assets within the trust and not the ultimate issuer (parent company). This change caused securities such as hybrids, military housing, credit tenant lease (CTL) and equipment trust certificates (ETCs) to become SSAP-43R securities. Given the expanded scope of SSAP No. 43R and the fact that the Modified FE rule penalizes premium dollar BBB to CCC securities, the industry wanted the Modified FE rule to go away. Opponents to the rule argued that it is not realistic that a single CUSIP, purchased at different prices, could have different designations and that the Modified FE rule could create arbitrage opportunities. After much deliberation, the Modified FE rule remains effective, but two important and positive changes were made:

Modified FE Rule Changes:

• CTLs and ETCs were carved out of its scope. The NAIC designations for these asset classes shall either be equal to an SVO generated designation or calculated by converting the security’s ARO ratings to an NAIC equivalent.
• The rating “staleness” criteria was removed. The rule previously required that all ARO ratings used when applying the rule be based on a review that occurred not more than 12 months from the reporting date. Since recent SEC and European Union requirements were put in place in 2011 which requires securities to be reviewed annually, the NAIC was comfortable removing this staleness criteria.

In 2010, the NAIC designations of structured securities ended with a “Z*” suffix to indicate that the asset class was under regulatory review. Since the asset class is no longer under review, one of the following new suffixes should be used instead:

AM – Indicates the designation was calculated using ARO ratings in conjunction with the Modified FE rule.

FM – Indicates the designation was calculated using RMBS/CMBS modeled data.

SM – This indicator is included in the Annual Statement Instructions. However, at the Fall 2011 meeting of the Valuation of Securities Task Force, it was     eliminated and therefore should not be used.

Below is a link to a useful flowchart, which outlines the process of rating SSAP 43R securities:

www.naic.org/documents/structured_securities_modified_fe_43r_flow_chart_final.pdf

Filing Exemption Lists for Government Securities

The SVO made several significant changes to the Filing Exemption Lists for Government Securities. The most notable change was the addition of the FDIC.

FASB

Fair Value Measurement (ASC 820)

In May 2011 the Financial Accounting Standards Board (FASB) amended the current Fair Value Guidance by issuing ASU No. 2011-04. The primary purpose of its issuance was to achieve converged U.S. GAAP/IFRS guidance. Although the amendment was quite large from a size (pages) perspective, it does not significantly change the application of existing fair value guidance. However, it may require additional disclosures.

Below are the significant accounting principles related clarifications/amendments in general terms:

• The “highest and best use” principle can not be applied to financial assets since they are perceived to only have one use.
• The fair value of a company’s own illiquid equity interests, distributed in situations such as business combinations, or liabilities where a quoted price for the transfer if an identical or similar liability is not available, should be based on the value of the instrument from the perspective of the asset holder.
• Certain criteria must be met for portfolios managed specifically with a risk management strategy to be measured as a whole versus at an individual security basis (hedging).
• Clarification is provided regarding the inclusion of premiums and discounts when measuring fair value. Illiquidity discounts should be incorporated in fair value, but a “block discount” (odd lot) should not be incorporated.

Below are significant disclosure amendments / additions:

• Disclosure of any reasons for all transfers between Level 1 and Level 2 (only required for public companies).
• Expansion of quantitative and qualitative inputs used in the measurement process of Level 2 and 3 securities. These disclosure requirements mirror the Annual Statement’s Note 20 (4).
• Description of the Valuation Process surrounding Level 3 Pricing
  • Description of Company’s Valuations Group, whom the Group reports to, and its internal reporting policies
  • Frequency and methods used to test pricing models (back testing)
  • Process used to examine changes in fair value across reporting periods
  • Support that third-party pricing is in accordance with ASC 820
• Sensitivity of Level 3 pricing to changes in the significant unobservable inputs. Below is an example disclosure taken from an Accounting Standards Update:

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption.

On the Horizon

FASB – Accounting for Financial Instruments

In May 2010, FASB released the Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. This exposure draft (ED) broadened the use of fair value measurement among financial instruments. However, since its release, there have been several changes that have scaled back this expansion. For example, the original ED required financial assets such as loans, core deposit liabilities and an entity’s own debt to be measured at fair value; the current version allows amortized cost. Additionally, the original ED required financial instruments that contained an embedded derivative (convertible bonds) to be measured at fair value with changes in value recorded in net income (FAS 115 Trading Classification). The current version retains the ability to bifurcate the host contract and the embedded derivative. Overall, the current guidance requires the classification and measurement of financial assets to be dependent on the characteristics of the financial assets as well as the entity’s investment strategy. The ability of a security to be prepaid such that the investor would not recover substantially all of the initial investment (interest only strips) is an example of a characteristic that would force a fair value through net income classification. Further, a company could have different measurement classifications for the same investment, if these same financial assets are held in different portfolios, with different investment strategies. Below  is a summary of the three proposed measurement classifications: Fair Value with changes recorded in Other Comprehensive Income (FV-OCI), Fair Value with changes recorded in Net Income (FV-NI), and Amortized Cost (AC).

FV-NI

• Derivatives or hedging instruments not designated as cash flow hedges or instruments to hedge a net investment in a foreign operation
• Instruments that can be contractually prepaid such that the initial investment will not be substantially recovered
• Marketable equity instruments
• At purchase , the investment is held for sale
• Measurement: Intially measured at Fair Value

FV-OCI

• Investment transferred to the issuer will be returned to the investor at maturity
• Total return strategy by either collecting contractual cash flows or selling the investment
• Measurement: Initially measured at transaction price

AC

• Investment transferred to the issuer will be returned to the investor at maturity
• Investments that are assoicated with consumer lending or financing activities
• Sales or settlements only acceptable if they are made to manage risk or more specifically to reduce credit loss
• Measurement: Initially measured at transaction price

NOTE: Subsequent reclassifications are not permitted.

The ED is also proposing a new “three bucket” approach to the review and recognition of impairments:

Bucket 1

• Securities with little or no credit loss deterioration since acquisition
• Impairment allowance calculation based on expected losses associated with pools of assets
• Impairment allowance shall represent the pool’s losses that are expected to occur over the next 12 months

Bucket 2

•  Securities with significant credit loss deterioration since acquisition
• Impairment allowance calculation based on expected losses associated with pools of assets
• Impairment allowance shall represent the pool’s losses that are expected to occur over the lifetime of the assets

Bucket 3

• Securities with significant credit loss deterioration since acquisition
• Impairment allowance calculation based on expected losses of the individual assets
• Impairment allowance shall represent the individual asset’s losses that are expected to occur over their lifetime

The “pools” associated with Buckets 1 and 2 are asset groupings, based on similar investment and risk characteristics.

The expected loss amount calculation shall be calculated based on a range of possible outcomes. Estimates of the likelihood of each outcome shall be made and the expected loss value should be a probability-weighted average. The guidance mentions that a loss rate method, which incorporates probabilities of default and loss given a default or a collateral valuation method would also be acceptable for calculating expected losses.

Transfers between the buckets can occur as credit deteriorates or when it improves.

It is important to note that this guidance is still being developed. Similar guidance (IFRS 9) has been issued by the International Accounting Standards Board (IASB) and its effective date has recently been extended to January 1, 2015. This extension was primarily made so the final U.S. GAAP guidance could be evaluated before IFRS 9 becomes effective.

NAIC Designation Recalibration Effort

The NAIC has studied the historical default rates, by ARO rating, levels and determined that different asset segments have significantly different historical default rates. For example, the default rates of Aaa corporate securities are comparable to the default rates of Ba and B non-general obligation municipal securities. Therefore, it is proposed that the ARO rating/NAIC designation mapping be different for the following asset segments:

•  Corporate Securities
•  Municipals
•  Asset-backed Securities

In addition to mapping changes, the proposal includes the expansion of NAIC designations, such that there could be an NAIC +1 and an NAIC 1. Given the number of factors (Asset Valuation Reserve, Risk-Based Capital, Modified FE Rule, Investment Policy) impacted by the NAIC designations, this proposal will be heavily deliberated.

Written by:
Joseph A. Borgmann, CPA
Vice President
Investment Accounting

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Commercial mortgage backed security issuance has rebounded dramatically since the depths of the financial crisis. While many of the egregious lending practices of the past have been rectified, there are elements of recent transactions that pose risks to investors.

The Commercial Mortgage Backed Securities (CMBS) market underwent a rapid transformation from late 2009 through 2011, growing from a market of small, single borrower deals to larger, multiple borrower transactions. Strong demand for these deals, CMBS 2.0 as they are popularly known, from both traditional and non-traditional participants, helped restore vibrancy and liquidity to the marketplace following the collapse of issuance in 2008. Despite increases in origination volume and transaction size over the past two years, CMBS 2.0 deals can be characterized as having relatively few underlying loans as well as lacking diversification in both underlying property type and geographic location. In addition, the original conservative underwriting standards prevalent in the first few transactions issued in 2009 have given way to aggressive origination practices, which has lead to loans with lower debt service coverage ratios (DSCR) and higher loan to value ratios (LTV), and, to a lesser extent, include some pro forma underwriting. We believe that at current yield spreads, investors are not fully compensated for the risk and volatility that is inherent in these new deals.

The first newly issued CMBS transaction, following the collapse of the structured securities market, occurred in November of 2009 after a nearly 2 year hiatus. This initial transaction was backed by a single loan covering a small collection of retail properties made to one borrower, Developers Diversified Realty (DDR). Given that the trauma of the financial crisis was fresh in investor’s minds, the underlying loan had very conservative lending metrics with a DSCR of 2.04x and an LTV of just 51.7%. This transaction was extremely well received and based upon this positive market feedback; loan originators again began extending credit to developers for securitization in future CMBS transactions. These new CMBS 2.0 transactions quickly evolved into more traditional conduit deals backed by multiple loans, covering several different property types made to a variety of lenders. The quality of the underlying loans remained quite strong as these early securitizations were backed by loans with credit metrics very similar to the DDR deal.

While the initial credit metrics were strong, the CMBS 2.0 transactions had much greater loan concentration due to the size of the loans and the relatively small number of loans backing each transaction. The average 2007 securitization contained 200 loans averaging less than $10 million per loan while the new securitizations contained only 30-50 loans and averaged $30 million per loan. As a result, the top ten loans in a CMBS 2.0 transaction make up a disproportionate percentage of each deal. Historically the top ten loans in transactions issued between 2004 and 2007 period made up between 30% and 45%, of the underlying pool while the top ten loans for deals underwritten in 2010 and 2011 averaged 69% and 62% of the pool respectively. This concentration increases the overall risk of the pool as the default of a single loan will have a dramatic impact on the overall credit performance of a securitization.

CMBS 2.0 transaction also lack diversified property types. Retail properties and office buildings comprise approximately 50% and 30% respectively of the underlying collateral pools. A large portion of these are located in tertiary locations such as regional malls and suburban office buildings. The tenants in secondary locations may not be as financially strong as those in primary central business districts and the time and cost to replace a tenant in the event of a vacancy can be much more difficult and expensive.

Evaluating these concentration risks becomes especially important as increased competition among lenders has led to a loosening of underwriting standards. Table 1, shown below, presents the declining average DSCR and increasing LTV ratio in recent CMBS 2.0 transactions. The rating agency stressed DSCR for GSMS 2010-C1 A2 (issued in 2010) was 1.45x, and the stressed LTV was 70.8%, as compared to an average for all transactions issued in 2011 of 1.24x and 90.6% respectively. While this trend is troublesome, these metrics still compare favorably to the averages at the market peak in 2007 when stressed DSCR averaged 0.98x and stressed LTV averaged 110.6%. 

Interestingly, interest only loans are becoming more prevalent, constituting approximately 21% of newly originated CMBS transactions. The lower debt service costs of an interest only loan make DSCR appear to be more conservative but in reality mask the risk in the underlying collateral pool. The lack of principal repayments during the term of the loan makes them more difficult to refinance at maturity leading to increased default risk.

Current underwriting trends in CMBS 2.0 transactions are troubling. Collateral pools concentrated in a relatively few regional malls and suburban office parks make these securitizations particularly risky. In the event of another broad based downturn in the commercial real estate market, the concentration in these securitizations make them much more vulnerable to credit downgrade and to principal losses on lower rated classes. Had the conservative underwriting standards of the first few transactions issued in 2010 been maintained, the risks would be manageable, however in light of the erosion of those standards, we feel that the return potential is not sufficient to offset the risks. As long as senior securities are offered with yields that are comparable to government guaranteed GNMA project loans, we’ll choose to avoid this sector for now.

Written by:

Mohammed Z. Ahmed
Assistant Vice President
Structured Products Analyst

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.