Posts Tagged ‘Treasuries’

The Tax-exempt sector was generally weaker across the yield curve relative to Treasuries during the first quarter of 2013. The sector started the quarter with very strong demand from reinvestment flows due to heavy January 1st coupons/calls/maturities, resulting in 10-year tax-adjusted municipal yield spreads to Treasuries tightening by 20 basis points (bps) into mid-January. However, technicals turned weaker during March as reinvestment flows declined and as investors began raising cash ahead of the April 15th tax-filing deadline. Overall, 10-year tax-adjusted municipal spreads ended the quarter at 93 bps, an increase of 18 bps over spread levels at the start of the quarter.

Supply has not had a significant effect on relative valuations. Supply during the quarter remained in line with volume from 2012. Total new issuance year-to-date stands at $81 billion, which is a modest increase of 2.4% relative to 2012′s supply through the first quarter. Refinancings/refundings, which had a substantial impact on total issuance in 2012, continues to make up the lion’s share of new issuance in 2013. Year-to-date, refinancings totaled $49.2 billion and made up 61% of total issuance. Although these totals are a modest 6% lower relative to the levels exhibited in 2012, refinancings have declined by an average of 31.2% over the past two months. The current low interest rate environment remains conducive for more refinancing supply to price, but if the recent declining trends in this category continue to play out during the balance of the year, it would be a market positive for tax-exempt performance.

In terms of our near-term outlook for the sector, we expect to see a challenging technical environment to develop, resulting in increased volatility in spread levels relative to Treasuries. Demand should improve as we move beyond the weak technicals tied to the tax-filing deadline. Additionally, municipals-to-Treasury yield ratios above 100% have historically enticed relative value investors to rotate into the tax-exempt sector and, as of April 1st, yields in 10-year municipals stood at 103% of Treasuries. Consequently, relative valuations appear to be attractive. However, supply expectations are ominous. Although new issue supply during April is expected to be a modest $30 to $35 billion, May and June should see a substantial pickup in issuance in the range of $40 to $45 billion per month. This amount of supply has typically overwhelmed the market and we should see spread levels move wider as this issuance clears the market. We would view the latter portion of the quarter as an attractive entry point to put more money to work in the sector, before market technicals strengthen dramatically heading into the summer months.

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.

Focus Will Be on the U.S. in the Second Half of 2012

• Volatility has Increased in the Corporate Bond Market But is Lower than 2011
• Expect a Lackluster Earnings Season
• Company Fundamentals Have Plateaued
• Performance for the Investment Grade Market in the Second Half of 2012 is Expected to be Subdued Relative to a Strong First Half
• Investment Grade Corporate Bond Spreads Continue to React to Economic Concerns

Volatility has increased in the Corporate bond market, reacting to a more pessimistic worldwide economic outlook. European fears remain elevated, despite positive headlines around the last summit, and investors are questioning the growth trajectory of the U.S. for the second half of 2012. Company revenue and earnings estimates have been revised lower, and mergers and acquisition activity has slowed substantially. Positively, after a subdued May, investment grade and high yield companies, both domestically and internationally, issued new bonds. Concessions for these new issues became more attractive, reflecting the market uncertainty. Investors reduced their exposure to Corporates, and broker-dealer inventory remains very low relative to historic levels.

Since our last publication in mid May, Corporate spreads are relatively unchanged after widening in May and tightening in June. Investors earned 2.63% in addition to their return from Treasuries for Corporate bonds in the first half of 2012. The spread over Treasuries for the Corporate market is currently at its last twelve month average, trading in a 61 basis point (bp) range this year, less volatile than its 103 bps range over the last twelve months (Exhibit 1). The Financial sector has outperformed by a wide margin (582 bps of excess return over Treasuries per Barclays), followed by BBB Industrials (187 bps). Five to seven year securities have outperformed longer dated bonds (461 bps vs. 178 bps).

Earnings Season Is Expected To Be Lackluster

The second quarter earnings season will be a good indication of how companies are dealing with the more challenging economic and political conditions. We note that company issued financial guidance for the second quarter is the most negative since fourth quarter 2008, and more analysts have cut guidance for 2012 earnings per share (EPS) than during the crisis last year (Exhibit 2). The strengthening of the dollar has resulted in downward revisions to estimates as well as lowered economic growth expectations.

Revenue growth expectations for the quarter are also the lowest since fourth quarter 2009. Margin compression is evident with revenue growth expected to exceed earnings growth after a period of margin expansion (Exhibit 3). Additionally, as shown in Exhibit 3, earnings expectations are quite high for the second half 2012 and for 2013, reflecting optimism regarding a resolution in Europe and worldwide growth. Lastly, we expect management to remain fairly guarded when communicating expectations for the second half of this year, which will not quell market fears of slower growth.

At an industry level, companies are managing the expectation for slower growth differently depending on industry conditions. For instance, as we get closer to the election, analysts have been revising down capital spending estimates for Defense contractors for fear that proposed spending cuts will crimp growth in this sector. This slowdown continues into 2013 for the sector. On the other hand, the Railroad industry continues to show growth having managed through the major slowdown in coal usage that is such an important part of their business. Capital spending estimates continue to get revised higher even as GDP growth slows. This is a testament to the Rail industry and its secular advantages.

Fundamental Improvement Has Plateaued

From a bondholder perspective, the cycle of credit enhancement has ended (Exhibit 4). The current environment of low interest rates and market volatility makes it less compelling for treasurers to continue to build cash, looking instead to increase their shareholder remuneration. As growth continues to slow, we recognize the increased likelihood that leverage is used to generate returns for shareholders. For most companies, we expect that to occur within their rating levels. That said, we have seen increased shareholder activism, pressuring management to be more aggressive with their balance sheets. To date, companies that have split or sold assets have generally done so without rating implications and material spread widening. We believe the market is becoming complacent by failing to recognize the deterioration of asset and cash flow protection for bondholders. We are taking a more cautious stance towards sectors that we expect will be challenged from a growth perspective, specifically Food, Defense, and Consumer Products.

Due to the strong liquidity and deleveraging that has taken place, default expectations remain very low and as such, very little spread over Treasuries is required to compensate one for default risk in the investment grade market (Exhibit 5). We do not expect that to change in the near term unless an unexpected event occurs in Europe or the probability of a recession increases for the U.S.

Macro Factors Will Continue to Drive Credit Spreads Over the Near Term with Particular Focus on the U.S.

Performing a regression analysis using economic and credit fundamental variables since 2009 to predict the Option Adjusted Spread (OAS) of the Investment Grade Corporate Index shows that approximately 80% of the variance in OAS can be explained by macro economic related variables. Adding more micro level variables (e.g., earnings revision ratio) increases this to approximately 93%. While we appreciate this relationship and apply a top down view to our credit analysis, we understand that at some point, credit spread volatility will be driven more by idiosyncratic vs. systemic risks.

Unfortunately, for the near term, we expect political and fiscal debates in the U.S. as well as events in Europe to drive spreads, keeping the market largely range bound around 200 bps. Our investment thesis remains unchanged, maintaining a more defensive Corporate portfolio. We continue to believe that Corporate bonds can produce positive returns over Treasuries in 2012; however, we do not expect the second half of the year to generate the level of excess return experienced in the first half (2.6% for the Barclays Capital Corporate Index). We anticipate a buying opportunity later in the year, when the risk of a U.S. recession increases.

Written by:
Elizabeth Henderson, CFA
Director of Corporate Credit

The municipal market experienced the impacts of the “January effect” a month earlier than anticipated. Very strong roll-over investment of heavy January 1, 2012 coupon/call/maturity proceeds has historically led to very strong municipal relative performance during January and February. However, falling supply conditions in December of 2011, combined with very strong demand across a number of buying segments, resulted in municipal yields falling by 39 basis points (bps) in 10-years during the month. That performance helped cap off an exceptional fourth quarter run that resulted in municipal tax-adjusted yield spreads versus Treasuries to tighten by 53 bps for the quarter.

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.