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.

Corporate Bonds Underperformed Again in November

It did not take investors long to turn cynical, selling risk assets once again in November. Corporate bonds underperformed Treasuries, widening 41 basis points (bps), generating -288 bps of excess returns in November with Financials posting the worst performance (-367 bps) and Utilities the best (-156 bps) per the Barclays Capital U.S. Corporate Index. Similarly, longer duration bonds (10+ year maturities) suffered most with 47 bps of spread widening, producing -566 bps of excess returns. Not surprising, the worst performing issuers included European credits (Telefonica, Telecom Italia, Eksportfinans ASA ) as well as credits with heightened credit risk (Amgen, Jefferies).

This did not keep issuers from the new issue market, as November marked the highest month of issuance from Industrial companies ($59 billion), bringing the gross supply for Corporate bonds to a healthy $75.4 billion for the month or $604.3 billion for the year . Net supply is $352.1 billion year-to-date. This reflects lower Financial issuance, as banks in the U.S. are over funded with deposits and European bank issuance is being shunned by the market.

December is starting off well with excess returns of 71 bps month-to-date as of December 9, 2011 per the Barclays Capital U.S. Corporate Index. That said, the lack of real progress made at the latest European Union (EU) Summit will likely result in waning performance through year-end as liquidity worsens.

Little Solved at the Summit Leading to Negative Rating Agency Press

The statements made from the European Central Bank (ECB) and European Banking Authority (EBA) were among the most scrutinized. The ECB announced that it would substantially increase its liquidity provision to EU banks in order to avoid a liquidity crunch. Included in the announced measures were unlimited three year funding (via its Long Term Refinancing Operation), relaxed collateral requirements, and a target rate cut for good measure. What was not included was a ramp-up in outright sovereign bond purchases through the Securities Market Program (SMP). In fact, European Central Bank President Mario Draghi explicitly repeated that the ECB would not act as the back-stop lender to the sovereigns, and he re-emphasized that it was up to the national leaders to come up with a fiscal solution to a fiscal problem.

The seventeen Euro members agreed in principal to a new treaty, outside of the framework of the existing EU treaties which preceded them. The new treaty would enshrine greater fiscal integration and automatic penalties for those that violate budgetary rules (to be administered by the EU bureaucracy). Specific details will be forthcoming by March 2012, and nine of the ten non-Euro members of the EU will likely also be signatories to the new proposed treaty (the United Kingdom has explicitly rejected further integration, very much in keeping with past precedent, citing encroachment on its sovereignty). Additionally, the EU central banks also agreed to contribute €200 billion, via the International Monetary Fund (IMF), in order to supplement the remaining capacity in the European Financial Stability Facility (EFSF), which was roughly €250 billion. Lastly, the EU leaders agreed to move forward the debut of the permanent replacement for the EFSF, the €500 billion European Stability Mechanism (still unfunded).

Standard & Poor’s and Moody’s reacted negatively to the Summit by reiterating their views that Eurozone countries could be downgraded by the end of first quarter of 2012 due to politicians’ inaction in the face of rising constraints, increasing the risk of adverse economic conditions. Specially, Moody’s stated :

The announced measures therefore do not change Moody’s previously expressed view that the crisis is in a critical and volatile stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While Moody’s central scenario remains that euro area will be preserved with out further widespread defaults, the shocks that are likely to materialize even under this ‘positive’ scenario carry negative rating implications in the coming months. Moreover, the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.

The timeframe imposed by the rating agencies for policy initiatives in the near future that stabilize credit market conditions effectively is too aggressive in our opinion, which increases the risk of rating downgrades and hence the risk of further shocks.

Liquidity is Important but Solvency is Critical

While the support by the ECB is a positive for the banking sector and we look to the ECB for eventual monetization of sovereign debt, it is not a panacea if sovereigns are insolvent. We are increasingly more concerned about the trajectory of Italy and Spain not to mention Greece, Portugal and Ireland (bank related debt specifically). The Financial Times highlighted the risk of low growth and high debt in an article in late November, pointing out that with borrowing costs of 4% and debt/GDP of 120%, Italy needs to grow at 4.8% just to avoid increasing its debt burden when it has a balanced budget. At 2% growth, its budget surplus will have to be 5% per year for 10 years to reduce its debt/GDP to 90% or begin to sell state assets. Even Germany will need to grow at 2.4% to avoid increasing its debt levels, and France even higher . This problem becomes worse as liabilities are increased to fund weaker EU members. We remain concerned that without true fiscal integration, the stop gap measures taken by the politicians and/or ECB will not appease the markets, increasing the risk of default at the credit and/or sovereign level.

AAM’s Corporate Investment Strategy is Defensive

We took advantage of the short lived rally to further reduce our holdings in Financials, a sector that will continue to ebb and flow with the news emanating from Europe. Our investment thesis is that Europe will remain volatile and the ECB will be forced to step in and monetize sovereign debt. At this point, our base case does not assume a departure from the EU, but we are aware that the risk is increasing. We expect lower than expected economic growth for Europe, as banks shrink their balance sheets to meet new capital requirements, governments become more austere and investors look outside of Europe to invest. Therefore, we continue to avoid European credit and invest in higher quality, liquid credits exposed to the U.S. and growing Asian and Latin American countries. At this point, we are comfortable with the economic landscape in China, but are watching that closely, cognizant of the ties the country has to Europe and domestic construction activity to fuel its growth.

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.

Over the past year, there have been a great number of rumors regarding a universal refinancing wave in the GSE (Government Sponsored Entities) agency mortgage market. We have witnessed a variety of national news stories regarding a government sponsored refinance wave and national media reports of a potential single thirty-year mortgage rate for every homeowner. These types of rumors have created many unpredictable days for the agency mortgage market and its investors. Despite the hearsay infiltrating the market, we do not believe that a universal refinance wave is likely.

In an effort to eliminate rumors and volatility in the market, the Federal Housing Finance Agency (FHFA) stated on October 24, 2011 that any new initiatives seeking to facilitate mortgage refinancing will be limited to the revamping of existing programs. Changes to the present refinancing plan, the Home Affordable Refinance Program (HARP), must be implemented in a manner that protects the taxpayers’ commitment to the GSE. The acting FHFA director, Edward DeMarco emphasized that while he was in favor of a program to aid homeowners, as the conservator of the GSE, he could only consider a plan that:

1. Conserves the assets of the Government Sponsored Entities (GSEs)
2. Preserves the liquidity and stability of the mortgage market and
3. Helps homeowners while considering the costs to taxpayers

The HARP program was initiated on March 4, 2009. The program was put into practice to help current and responsible homeowners refinance at today’s lower mortgage rates, despite sharp decreases in home values. The government program was expected to help between 4 and 5 million homeowners when activated in April 2009. As of July 2011, however, only 20% of those homeowners were actually able to refinance. The program’s initial termination date was intended to be June 30, 2010 and has been extended three times now. The new termination date is December 31, 2013.

On Monday, November 15, 2011 the FHFA sent out a press release regarding the changes to the existing HARP program. Due to the mandates of the FHFA, those tweaks to the program did not create a massive refinancing wave. The changes are outlined below:

• Reducing risk based fees – Loan Level Pricing Adjustments (LLPAs)
• Elimination of the 125% LTV (loan to value) ceiling for fixed rate mortgage loans
• Adjustments to representations and warranties
• Streamline some property appraisals
• New program effective December 1, 2011
• HARP extension to December 31, 2013

The removal of Loan Level Pricing Adjustments will lower the cost of refinancing and encourage more borrowers to refinance. LLPAs were increased by both agencies in 2008 causing some of the recent difficulties in refinancing. LLPAs are special fees charged by the GSEs to guarantee any loan with a low credit score (FICO score), a higher LTV (loan to value) ratio or a feature deemed risky by the agencies (e.g., higher debt to income ratios, investor properties, second home, etc.). These fees generally range from 0.25% to 2%, but have been as high as 3%. There was a recent cap at 2% for certain loans that the agencies refinance from their own portfolio. Many times these fees were paid upfront or rolled into the total mortgage. When you look into the raw numbers of an extra 2% or a 3% fee ($8,340 or $12,510, respectively) on a $417,000 loan, it’s obvious why this could impede a homeowner to refinance. Reducing these LLPAs will increase prepayment mildly.

Another change is eliminating the 125% LTV cap and streamlining some property appraisals in certain qualified areas. Removing the LTV cap will help a small percentage of underwater homeowners (home is worth less than they paid) become eligible to refinance. An estimate of qualified HARP homeowners that hold an agency mortgage with an extremely high LTV is said to be about 1% to 2% of the agency mortgage universe. A small percentage of homes will not require appraisals but will be valued using a GSE’s housing model that will ease the refinancing process.

Changes to representations and warranties can be the most complicated HARP alteration. A change to “reps and warranties” essentially revisits underwriting flaws for lower creditworthy borrowers. It seemed to be a trend in the past that the insufficient mortgage underwriting was focused on the lower creditworthy and lower documentation type borrowers. Originators “supposedly” had confirmed property valuations, borrower’s incomes, assets, employment, etc. at origination. If the originator cannot prove the loan was adequately underwritten, the GSE can force the servicer to buy the loan back (called a “put back”) in a new mortgage default.

It seems that this “put back” capability by the GSE hindered certain loans from being refinanced by the mortgage originator. One main reason for this problem is if these loans did default within 12 months of a refinancing, the originators are responsible for the loss. The loss would be assumed to be 40 to 60 cents on the dollar for each mortgage when the loan is put back. The originators today are unwilling to rep and warrant many of the older “qualified” borrowers of years past because of this potential put back loss. This potential default on a less creditworthy borrower and fear by the mortgage originator has slowed the HARP refinance program. In general, the detailed changes were minimal on reps and warranties for Fannie Mae and a little more meaningful for Freddie Mac, who waived most reps and warrants.

To qualify for the program, the loan must be a first lien and owned or guaranteed by either agency. Loans that originated and sold into private label securitizations are ineligible for the HARP program. In addition, the mortgage must be current for Freddie Mac (no late payment within the last 12 months) and the qualifier can only have been 30+ days delinquent once in the last 12 months for a Fannie Mae loan. Based on Mortgage Bankers Association statistics, we have seen 30+ days delinquencies on mortgage payments reach as high a 10% nationally and now has dropped to the 8.5% area. These numbers alone eliminate more than 8% of the market from possible refinancing.

Recent Agency Mortgage Prepayment Speeds

It’s interesting to compare historical prepayment speeds across different MBS to see exactly how speeds have changed from historic norms. The lack of credit available to lower FICO borrowers and the ineffectiveness of the original refinance program has prevented many homeowners with a 5.5% to 7% mortgage rate from refinancing. If you look at Exhibit 1 (view original document ( PDF) to see) for the generic 30-year Fannie Mae guaranteed mortgages this month, you will notice that the higher coupon borrowers are prepaying more slowly relative to lower interest rate borrowers. Of note are the 6% through 6.5% coupons. These coupons are paying slower than 4.5% through 5.5% coupons. In past low interest rate environments, 30-year 6.5% coupons have paid between 55 and 93 Constant Prepayment Rate (CPR) depending on year of origination.

The FHFA estimates close to one million more homeowners will be eligible to refinance under the modified program. The new HARP program should not cause a massive refinance wave. You will see prepayments increase in speed from 3% to 12% to different degrees across a variety of Mortgage Backed Securities. The prepayment increases in 30-year agency Freddie Mac and Fannie Mae mortgages should not be substantial or shocking to the market. While speeds will increase in 2012, we believe current MBS prices have factored in this increase and the market is fairly valued. The HARP changes most likely will not be felt by the market until early 2012.

Written by:
Christopher M. Priebe
Vice President, Mortgage Backed Securities Trader

To read the Fannie Mae and Freddie Mac November 15, 2011 announcements, click on the links shown below:

http://www.fanniemae.com/mbs/announcements/2011/mbs_announcement_111511.jhtml?p=Mortgage-Backed+Securities

http://www.freddiemac.com/sell/guide/bulletins/pdf/bll1122.pdf

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.

 Economic Backdrop is an Important Factor for Consideration

Perhaps the most important driver of retail sales is the willingness of the consumer to spend. To do this, we focused on nine categories which help us gauge the overall health of the consumer. We analyzed the most recent economic data points for each category and made a simple assessment for each category relative to data posted in November/December of last year (Exhibit 1).

An average of all the categories returned a score that was halfway between “Neutral” and “Negative”. Looking forward, we think household wealth could turn negative when third quarter data is released from the Federal Reserve given the significant drop in the stock market. An offset might be more favorable gasoline prices if the trend towards cheaper gas continues through the end of the year. In summary, we believe that the consumer is in a slightly weaker position today versus the holiday months of 2010. Recently, better economic data resulted in third quarter GDP of 2.5% coming in better than expected thus reducing the risk of a double-dip recession. However, we acknowledge this was largely as a result of consumers spending more, but using savings to do so.

 Statistical Analysis Indicates a Stronger Season

Looking back on data over the last fifteen years reveals a strong relationship between “Back to School” retail sales (August and September) and “Holiday” sales (November and December). Strong “back to school” sales tend to lead to strong “holiday” sales and vice versa. To complete this analysis, we used the Bloomberg Same Store Sales Composite Index which includes a variety of retailers in the department store, discounter, and specialty subsectors. The regression model returned an R-squared statistic of 64% which means that “Back to School” sales explain 64% of the variability in “Holiday” sales. The model predicts “Holiday” sales of 5.0% when using 5.4% for the “Back to School” sales observed in 2011. This would be significantly better than the average which was 2.7% over those fifteen years. We recognize that this is strictly a mathematical analysis and does not include any qualitative data as inputs.

 Seasonal Hiring is Weaker than Last Year

The National Retail Federation (NRF) predicts the retail industry will hire between 480,000 and 500,000 seasonal workers this holiday. That compares to 496,000 workers hired in 2010. In addition, Challenger, Gray, & Christmas thinks seasonal hiring will be about flat to slightly lower than last year. The Hay Group reported that about two-thirds of retailers expect to bring the same amount of workers back this holiday season while about 25% said they will bring back fewer workers. All of these various estimates reflect a muted tone from retailers for this holiday season.

Price Increases are Necessary for Sales Growth

Historically, retailers have not been able to pass on the full effect of rising costs on to the consumer for fear of losing volumes and market share. This is illustrated in Exhibit 2 as the positive difference between apparel Producer Price Index (PPI) or producer costs and Consumer Price Index (CPI) or consumer costs. We expect price increases to be the main driver of sales for retailers this holiday season. CPI has been above 3% for the last six months. CPI is estimated to be up 3.4% year over year in the fourth quarter of 2011.

Retailers are always trying to balance lower margins and higher sales. This will be a bigger problem for those retailers that focus on basic items as opposed to those that have more fashion forward (inelastic) products. Going into the holidays, department stores and discounters are expected to be running inventories at relatively conservative levels. This should help to keep margins in check. In addition, we expect promotions to pick up as we haven’t heard much about “must have” new gift items. In the past, those kind of items have included TVs, cell phones, e-tablets. We don’t believe price increases will follow an increase in costs this holiday season. In addition, retailers are expected to increase promotions in an attempt to avoid lower volumes. In summary, there’s limited ability for retailers to drive same-store-sales with increased prices above what we expect from inflation.

Cyber Shopping is Expected to be Strong

Online shopping has become so popular that the industry has coined the Monday following Thanksgiving as “Cyber Monday.” Most retailers have recognized the importance of online commerce as more than two thirds expect sales to be up 15% or more compared to last year. Many retailers have enhanced their web sites and have already starting promoting the holiday season on social platforms such as Facebook and Twitter. Ease of use, convenience, ability to compare prices, and free shipping offers are some of the main reasons why consumers shop online. A survey by the NRF showed that the average shopper plans to do about 36% of his or her shopping online in 2011, compared to 33% last year. While this trend is positive for the industry, there are still a lot of other important factors to consider as online sales typically represent only about 5% of total retail sales. As shown in Exhibit 3, some retailers are more focused on e-commerce than others. In particular, the department stores have done a better job penetrating this market than others. We expect the growing popularity of e-commerce to help sales this holiday season.

Inventory Management has Improved the Sales Process

Another important trend for the retail industry has been the improvement in inventory management. Controlling inventory is one of the most critical operating activities for a retailer. It is a delicate balance between having enough inventory, so sales aren’t lost and having too much, so the product doesn’t have to get discounted. Since the last economic recession, companies have invested a lot of capital into technology that integrates inventory across all channels, including the entire store base and central warehouses, which support the online business. Inventory has become more transparent to the shopper and the sales associate who is trying to win a sale. A customer who is searching for a product on a retailer’s web site can either order the product online to be shipped to the home or to a local store. A very convenient feature for the customer is the ability to see if a particular product is in stock at a nearby store. Behind the scenes, inventory moves from store-to-store, from warehouse-to-store, or directly to the customer’s home. Also, retailers have become more localized in their merchandise decision making process. With better inventory systems, retailers have the ability to more closely monitor inventory so product that is not selling well in a particular region can be moved to a different location. Some retailers have equipped their sales associates with mobile devices with real-time access to inventories and the ability to complete a sale on the spot. At the end of the day, inventory management has become more productive and the customer receives a better service experience. We expect these improvements to improve sales and margins as fresh product reaches shelves more quickly and markdowns are reduced. In addition, retailers are also investing in their supply chain. Shorter cycle times and improved reorder capabilities are resulting in better product success and more conservative inventory positions.

Survey Results Indicate Consumers will Spend Prudently

Exhibit 4 shows the results of a survey conducted by the Citigroup retail group. The survey was an online holiday survey which included more than one thousand responses for consumers between the ages of 18 and 65. About half of the respondents plan to spend the same as last year. That’s up from 45% last year and 41% the year before. And 10.2% said they would spend more in 2011 which was the same as last year. The survey reveals a slightly more optimistic consumer. Other interesting observations were: more consumers are looking for discounts, more consumers will shop online this year, and consumers are most concerned with the economy this year versus job status/income last year.

Summary

In summary, we see no reason for retail sales this holiday season to be much different from the average year over year growth of 2.6%. The tone of the typical consumer and the drivers of their spending patterns are a bit weaker now than when compared to last year. A lack of exciting items along with discount hungry shoppers will make it difficult for retailers to push up prices without sacrificing significant volume. Having said that, we believe retail sales will end up slightly better than the average helped by some important trends in the retail industry. Forced by the perils of the latest economic recession, retailers have become much smarter and more conservative. This has been helped through the addition of better inventory and supply chain systems. We expect e-commerce to continue to grow and become a larger proportion of total sales. We believe it will continue to help drive overall retail sales in the future. Finally, our regression analysis based on ‘back to school” sales returned a holiday sales number closer to last year’s 4.6%.

Credit Selection

We continue to be very selective when considering opportunities in the retail space. The economy remains very sensitive while news flow concerning the European debt crisis has kept global capital markets incredibly volatile. In addition, the retail landscape continues to evolve and competition has never been more cutthroat. We favor those credits that either benefit from a positive secular trend (e.g., CVS) or have proven their ability to succeed in a particular niche (e.g., Home Depot, Nordstrom). For higher quality focused investors, Wal-Mart and Target continue to be very strong operators. Both have taken market share away from traditional grocery stores and middle-market department stores.

Written by:
Michael J. Ashley
Vice President, Corporate Credit

 Results were Favorable for Corporate Bonds in October 

After months of debate, European leaders finalized their plan, and investors didn’t wait to see the details. The tail risk resulting from a disorderly Greek default appears to have been reduced in the near term, and the domestic economy performed better than the markets expected. Hence, the increased appetite for risk by the markets. Corporate credit spreads tightened 36 basis points (bps) in October, generating 273 bps of excess return per Barclays Corporate Bond Index. Despite outperforming in October, the Finance sector has underperformed year-to-date, 93 bps wider compared to the Industrial and Utility sectors that are 27 and 22 bps wider, respectively. New issue supply has picked up in both investment grade and high yield, and new issue spread concessions have begun to normalize as deals are oversubscribed. Dealer inventories remain very low historically, a technical that should support spread tightening based on current demand. 

 AAM’s Corporate Investment Outlook Remains Constructive Yet Selective 

 Because we were more optimistic about the domestic economy and did not believe a tail event would occur in Europe, we did not feel it was appropriate to reduce our Corporate positions meaningfully, as it becomes a strategy of market timing, which is dangerous given volatile Treasury yields and poor liquidity (Exhibit 1). 　Instead, we have reduced credits vulnerable to weakening economies and sovereigns or funding needs, believing the right security selection over time in this low growth environment will lead to outperformance. The reality that rates will remain low for some time should result in spread compression between higher and lower rated credits, as seen earlier this year. Unfortunately, for 2011, we are no longer expecting to exit with positive excess returns for the market given the risk premiums that will remain in various sectors to compensate for the volatility and uncertainties. 

Fundamentals remain very strong for U.S. domiciled investment grade companies. Case in point, third quarter earnings reports have been better than expected with most industries surprising to the upside and reporting both earnings and revenue growth. That said, sovereign risk remains elevated in the U.S., as we face our own fiscal challenges (Exhibit 2). 

In Europe, the environment from both a sovereign and an economic perspective is more concerning. While the European banks reported better than expected loan growth and credit costs in the third quarter 2011, bank balance sheets are likely to contract over the near term due to the requirement for capital improvement and the austerity measures will take hold, both dampening economic growth. Moreover, according to a recent Goldman Sachs study, European company fundamental improvement is lagging, providing less of a cushion for creditors. Whereas, the U.S. nonfinancial corporate sector’s credit quality is close to its highest level in decades, European firms have only reverted about two thirds back to pre-crisis strength. 

 Sovereign Risk Remains in the Forefront 

This month, we thought it worthwhile to review the European plan, and provide our thoughts on the details. Our investment strategy in the region remains unchanged: avoiding European financial, infrastructure, and economically sensitive companies. We expect continued volatility until we see greater economic and fiscal stabilization in Italy and Spain. 

 Greek Debt Restructuring 

Private investors (i.e., banks/insurance companies) agreed in principal to a 50% reduction in their holdings of Greek sovereign bonds.　 This haircut would apply to the approximately €210 billion of privately held debt but not to the €150 billion International Monetary Fund (IMF) or European Central Bank(ECB) held debt. The IMF estimates that this would result in a debt/GDP ratio of 120% as of 2020 (vs. currently projected 180%). 　This strikes us as a half measure, but it avoids, for the moment, a disorderly default in Greece. We await details of the new government, recognizing the elevated uncertainty and thus risk, but are reassured that despite angst over austerity measures and their national sovereignty, more than seven of ten voters said they favored Greece remaining in the Eurozone per a poll two weeks ago in the To Vima newspaper. 

 Bank Recapitalization/Liquidity 

European banks will be required to achieve a 9% “core” Tier 1 capital ratio no later than June 2012 after a mark-to-market of all sovereign holdings (using sovereign prices and exposure as of September 2011).　 The European Banking Authority (EBA – engineers of the Euro Stress Tests) estimate a Eurozone capital deficit of €106 billion based on the figures and marks as of September 30, 2011. The recapitalization plan calls for banks found to require capital to first attempt to tap private markets (for common equity or “strictly underwritten contingent capital instruments”), followed by withholding of dividends and bonuses, reduction of high risk weighted assets, and only if these measures are insufficient, capital injections from the national governments or the European Financial Stability Facility (EFSF) if the national governments do not have the means (i.e., Greece, and possibly Spain and Italy).　 The banks must submit a capital raising plan to their national regulators and the EBA no later than December 25, 2011. 　The bulk of the €106 billion recap falls on Greece (€30 billion), Spain (€26 billion) and Italy (€15 billion). It should be noted that the €106 billion capital shortfall estimate is based on the July 2011 EBA stress test base case (which already appears somewhat optimistic), and does not take into account the prospect of further GDP slowdowns in either broader Europe or those countries most affected by fiscal consolidation measures (i.e., Greece, Italy, Spain).　 

The Eurogroup announcement also contemplated a sovereign guarantee scheme for bank term funding from 2012 on in order to prevent either a buyers’ strike or “excessive deleveraging” by banks that are trying to achieve the Tier 1 targets through balance sheet reduction. 　This would be separate from the ECB liquidity provision efforts (and likely would aim to replace it ultimately). 　Details of this program are completely to be determined, but should be supportive of Euro area bank spreads as it further reinforces bank access to term funding over an intermediate period and reduces fears of a liquidity squeeze. 

 “Upsized” EFSF 

 While there is explicitly no increase to the €440 billion contribution of the Aaa/AAA countries (Germany, France, Netherlands, Finland), the Eurogroup will continue to explore two options for leveraging the structure in order to facilitate approximately €1 trillion of new sovereign issuance: 

1. Insurance Option - This would see the EFSF offering a partial wrap on new sovereign issuance (20% first loss absorption has been the amount rumored). 　This would effectively allow a €200 billion commitment from the EFSF to backstop the contemplated €1 trillion of issuance (roughly equivalent to the issuance needs of Spain and Italy over the next 18 months).　 The Eurogroup contemplates such insurance being discretionary (i.e., provided only if investors explicitly request it) and there has been no discussion of pricing.
2. Special Purpose Vehicle  – This would see the EFSF fund a Special Purpose Vehicle (SPV) with a first-loss equity piece that would then purchase new issue sovereign debt and sell a senior tranche of bonds to private investors. This is the closest structure yet to a “common Eurobond” issuance and is the structure that market participants seem most enthusiastic about.　 A good way to think of this approach conceptually is that it is using cash Collateralized Debt Obligation (CDO) architecture.

 The Eurogroup has promised details on both of these options in November 2011 and may use either or both approaches. 　Still to be determined is the market’s receptivity to a 20% first-loss protection (on assets that had previously been treated as 100% risk-free/0% risk weighted). 　Additionally, we note that the EFSF has raised less than €20 billion of the contemplated €440 billion funding capacity. The latest €3 billion 10-year bond was downsized from the originally planned €5 billion 15-year after demand was tepid. It was sold today at a spread of 177 bps over German bunds with Central Banks accounting for 35%, Banks 30%, Insurance companies 20% and Fund Managers 15%. 

Our Thoughts on the Credit Implications 

This plan appears to nominally address many of the outstanding issues (i.e., Greek restructuring, bank capitalization, EFSF mechanism for supporting sovereign liquidity), but the key to resolving the Eurozone crisis is the ability of Italy and Spain to achieve a more stable fiscal trajectory (Exhibit 3).　 In that respect, the actions announced by the Eurogroup are really just treatments of the symptoms, rather than curing the underlying ailment. 　Ultimate resolution of the crisis depends on Spain’s, and especially Italy’s ability to implement their fiscal consolidation plans (without backsliding) and to achieve the projected (or at least reasonable) levels of GDP growth in the face of fiscal austerity and considerable domestic political resistance. 　Their success or failure in these efforts will likely not become apparent for another twelve-to-twenty four months. 　Until we see clear evidence that Italy and Spain are demonstrating political commitment to fiscal consolidation and clear economic and fiscal progress, we will remain very cautious of the continental European sector. 

Written by: 

 Elizabeth Henderson, CFA�
Director of Corporate Credit 

 N. Sebastian Bacchus, CFA�
Vice President 

Who Makes Private Label Products?

Private label products are made by several types of manufacturers. Some large brand manufacturers use their excess capacity and expertise to produce private label products. These products may be sold into foodservice venues or retail locations. For example, Hormel Foods sells a line of private label food products which includes canned meats, desserts, bouillon, and sugar and salt substitutes. This is in addition to the company’s Dinty Moore, SPAM, Lloyds, and Jennie-O branded goods (www.hormelfoods.com). Some retailers own their production facilities. About 40% of the private label products that Kroger sells are produced at the company’s own manufacturing plants which consists of 18 dairies, ten deli and bakery plants, five grocery product plants, three beverage plants, two meat plants, and two cheese plants. Finally, there are exclusive manufacturers of private label goods. These types of companies range from small, focused, or regional to large and diversified. With about $4.5 billion of annual revenues, Ralcorp is the largest private label food manufacturer in the U.S. This compares with revenues of $52 billion for Kraft which is the largest branded food manufacturer in the U.S. All of these manufacturers have the same high standards as the branded producers. They use similar equipment, similar ingredients, undergo a similar testing and quality analysis, and abide by the same set of FDA regulations.

Buying Private Brands is Good for Consumers & Retailers

When it comes to taste, it’s very difficult to tell the difference. There have been several surveys published which illustrate consumers’ growing satisfaction with the private label product quality. Exhibit 1 shows the results of one such survey completed by The Nielson Company.

It was the lower price point that got consumers more interested in private label food during the last economic recession. It has been the improved product quality and value proposition that has kept consumers coming back for more. Traditionally, private label products have focused on the low-end price point. Now, some retailers will offer private label products across multiple price points including a premium line. This has made it more difficult for the brand manufacturers to differentiate themselves.

The private label trend has been positive for many retailers. Those retailers that sell private label goods make a significantly bigger margin on those sales. According to Steven A. Burd, CEO of Safeway, generally, food retailers make a 25% gross margin on branded product sales compared to a 35% margin on private label sales. That’s a significant source of additional profitability for a competitive business such as food retail. The use of private label products also gives the retailer the flexibility to more easily align a specific customer need with a specific product. For example, a grocery store in Chicago could make an observation that customers like their salsa very spicy and made with a specific kind of hot pepper. That change could be made quickly, especially if that grocery store had its own manufacturing facility for its private label salsa product. As a result, that store has improved its sales, enhanced its profitability, and improved its customer loyalty. Private label penetration in food has been increasing. For some retailers the sale of private label products can account for as much as 26% of unit sales and 20% of dollar sales.

The cost savings for the typical consumer is large. The Private Label Manufacturers Association performed a pricing study that compared a basket of brand name products to a basket of private label products. The result was a 35% savings (See Exhibit 3).

 Why Buy Brands?

So, for basically the same basic product at a lower price, why would anyone buy the branded alternative? One reason, is brand loyalty. Consumers know what they like and most don’t have time to stop and look at alternatives while shopping. Also, shopping for certain brands instills a certain sense of nostalgia that you don’t get from private label products. Also, the top brand manufacturers are typically very good at coming out with new, innovative products. A couple of examples include the new Heinz Dip and Squeeze ketchup package, and Kimberly Clark’s new Kleenex Cool Touch. You won’t get leading edge products from private label manufacturers. Finally, many cultures use branded products as status symbols. Products like Nike shoes and Coach purses are well recognized brands that help define one’s status. This has been a relatively new development for emerging markets as certain socioeconomic groups improve their wealth. This is positive for the branded manufacturers as they continue to push into countries such as China, Russia, and India.

 Private Label Performance

It’s interesting to take a look at the performance of private label products over the past five years. Exhibit 4 shows the price gap widened from 2007 through 2009.

During this period of time private label market share was increasing at a steady rate. This was due to a combination of three things: lower prices versus brand products, improved quality of private label products, and falling consumer confidence. As we exited the recession toward the end of 2009, consumer confidence started to come back.

Exhibit 5 shows the price gap closing from 2009 through 2011. Brand manufacturers began to invest more heavily in “price” (lower prices of their products), in effect reducing the incentive for consumes to switch to cheaper private label products. As a result, branded goods regained volume market share. As shown in Exhibit 6 and 7, the battle seems to have come to a stalemate as the price gap has shrunk and consumer confidence has waned. For the latest four weeks ending September 3, 2011, branded prices have increased 6.4% resulting in a loss of volume of 2.3%. Private label prices increased by 9.9% resulting in a similar volume loss of 2.2%.

Private Label and Credit Research

We carefully consider the threat of private label when assessing the fundamental strength of a credit. It’s very helpful to know how a company is positioned relative to private label competition. In general, those companies that have focused on growing their private label presence have benefited with better profitability. Private label brands such as American Rag and Ink are sold at Macy’s and altogether represent about 20% of sales which is up from less than 5%. Among other things, when researching branded food manufacturers we are careful to consider a company’s diversity of product categories in addition to its market position in those categories. A company with a narrow product focus and weak market position is at greater credit risk. In food manufacturing, there are certain categories that have a much bigger competitive threat from private label. These categories, such as cheese, nuts, and milk tend to be more commodity like in nature. For these reasons we favor large, well diversified, food companies such as Kraft, General Mills, and Kellogg. On the retail side, we like companies that are strong operators, benefit from a specific niche or secular trend, and take advantage of attractive private label opportunities. These credits include Home Depot, CVS, Kroger, and Nordstrom.

What’s Next?

Going forward, we expect private label products will continue to be a formidable threat to branded manufacturers. Branded manufacturers will need to enhance innovation and focus on the way they market their products as they compete for shelf space next to grocery stores’ private label products. Retailers will continue to increase their proportion of private label product as a means to improve profitability and enhance the consumer’s shopping experience. In the future, it should be interesting to see how the industry adapts given this private label dynamic. After all, just look how far we’ve come since those days of black and white labels.

Written by:
Michael J. Ashley
Vice President, Corporate Credit

Demand for municipals has generally been strong all year as the sector continues to allay fears of substantial default risk. Although municipalities continue to face ongoing budget challenges, so far they’ve met these challenges head on with austerity measures that have led to over 680,000 cuts in payroll since the third quarter of 2008. In addition, tax revenues have also seen a steady climb. State and local government revenues rose another 6.9% during the second quarter according to the U.S. Census Bureau, which marked the seventh-straight quarter of growth. These positive developments have resulted in the sector reporting defaults of only $1.1 billion during the year, which is about a quarter of the total exhibited in 2010 and well-below the predictions of over $100 billion. 

Although demand has seemingly been consistently strong all year, much heavier supply over the last four weeks through October 7, 2011 resulted in a drastic level of underperformance relative to Treasuries. An average of approximately $8 billion per week came to market during this period, with $9 billion pricing during the first week of October. That helped pressure municipal yields higher by 48 bps in 10-years, while Treasury yields in 10-years were higher by only 16 bps. Additionally, the heavier supply conditions also forced many of the new deals to price at substantial concessions to historical spread levels to clear the market. The overall rise in yields resulted in the relative value profile for the sector to reach 2-year highs on October 7th, with tax-adjusted and nominal yield spreads to Treasuries reaching 172 bps and 56 bps, respectively. 

The near-term outlook for the tax-exempt sector is positive. The substantial relative-value attractiveness of the municipal sector should continue to attract a number of buyers, including non-traditional cross-over investors who can’t use tax-exempt income. These buyers are primarily looking at the substantial dislocation in relative valuations as measured by the municipal nominal yield advantage to Treasuries and are betting that these dislocations eventually revert to their historical means. This demand trend is expected to help provide the sector with the needed sponsorship to help absorb what’s expected to be heavier supply flows through the last three months of the year. 

Through the first three quarters of 2011, new issue supply has been running below 2010′s levels by approximately 35%; however, the current extremely low yield environment has created a new wave of unexpected refinancing/refunding opportunities for issuers. This potential additional supply, in conjunction with the typical increase in supply that occurs during the fall months, will lead to continued spikes in volatility in tax-adjusted and nominal yield spread relationships. It’s expected that crossover investors, traditional and non-traditional alike, will continue to treat these spikes as buying opportunities. As we move into December 1st and January 1st, demand should also increase as heavier reinvestment flows from coupon/calls/maturities enter the market. These positive demand technicals should result in tax-exempts outperforming Treasuries during the fourth quarter, especially if we see a substantial rise in Treasury rates from current levels. 

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