AAM Newsletter: Winter/Spring 2015
March 31, 2015
By John L. Schaefer, CFA
As we close out the first quarter, the investment environment has continued to be challenging for insurers with persistently low interest rates. Through our meetings with clients, we hear a renewed focus on underwriting and strategic investments in technology and systems upgrades to improve the other side of the balance sheet. We have found that the markets have presented short term dislocations, but this is an environment where a focus on credit analysis is critical to avoiding potential portfolio issues.
AAM had another outstanding year in 2014 of providing top-tier investment performance, demonstrating the value of our nimble and flexible investment platform. We have seen positive momentum with clients allocating additional assets to AAM due to our excellent performance, client service and reporting. Our surplus growth strategies, led by the AAM/Zazove Convertible Bond program, have been positive contributors to our clients’ overall results with strong risk-adjusted performance.
On the business front, I continue to be pleased with the level of support from our new partner, Securian Financial Group. The acquisition to acquire the majority shares in AAM closed at year end, with Securian investing alongside our Principal Employee Members. As we had communicated, we have maintained complete independence and there have been no changes to AAM’s people, processes, systems or location.
By Reed J. Nuttall, CFA
Chief Investment Officer
The market expected that the Fed would remove the word “patient” from the official text on the March 18, 2015 meeting. Although they removed that language they added further soft language tying further rate increases to higher inflation. The market was somewhat caught off-guard: we saw interest rates fall, the U.S. dollar weaken, and the stock market drop on this Fed news combined with an increasingly negative outlook for first quarter growth.
The market was somewhat caught off-guard: we saw interest rates fall, the U.S. dollar weaken, and the stock market drop
The lone bright spot seems to be the strength in the U.S. employment picture (295,000 in February and 239,000 in January) which could give the Fed reason to hike rates sometime in the last half of the year.
With U.S. rates significantly higher than in the rest of the developed world the U.S. Dollar has appreciated considerably versus a basket of currencies, up 10.9% in 2014 and 5.3% thus far in 2015. This strength has contributed to keeping rates low with the 10-year Treasury currently at 1.96%, down from 2.17% at year end. We believe that it’s unlikely that 10-year and longer interest rates will rise significantly in the face of global deflation and a very strong U.S. dollar.
Within these constraints, we favor high quality Corporate bonds, using this low rate environment to move up in quality. We think the liquidity and quality offered by short ABS securities make them attractive. We are underweight Agency MBS as the strong demand from the Fed has created a supply/demand imbalance within this market. Both CMBS and Taxable Municipals are fair, and we are cautious in the CMBS sector as overall underwriting standards are a touch sub-standard today. We continue to underweight Treasuries as the sectors mentioned above are attractive and provide more income for our insurance company clients.
Muzinich & Co. High Yield Webinar Recap
AAM’s sub-advisor Muzinich & Co. recently held a webcast to discuss the impact of falling oil prices on the U.S. high yield bond market. In the webcast, “Finding Value in Energy Sector,” Clint Comeaux, portfolio manager for the U.S. high yield strategy, discussed the supply demand imbalance that exists within oil production and how this has led to a widening spread differential between the U.S. high yield market and the energy sub-segment.
The substantial drop in oil prices was caused by a supply demand imbalance. The imbalance resulted from a growth in supply without a matched demand, causing a drastic price decrease. Demand for oil has not grown fast enough to keep up with the supply. The crude market is oversupplied by non-OPEC producers (U.S. shale development produces over a million barrels/day). In addition to non-OPEC members contributing to the oil supply, OPEC producers, such as Libya and Iraq and potentially Iran, have exacerbated the oversupply.
Since the summer of 2014, spot prices have experienced a greater than 50% drop in value, far more than forward prices for the commodity. Before this price correction, the forward market predicted that $100 a barrel was unsustainable. Similarly today, with spot prices at $50 a barrel, the forward market suggest that these levels are unsustainable. While it is difficult to predict the exact timing, our expectation of the normalization of oil prices will be gradual and take place over an extended period of time.
When examining WTI Forward prices, the drop in spot prices since last summer has been more than 50%. When prices reached over $100/barrel, the market predicted that it would not be sustainable and it would normalize at a lower level. The slow recovery ahead of us will lead to a normalization of prices – slow being the key term.
Falling oil prices have led to a widening spread differential between the U.S. high yield market and the energy sub-sector. Energy related credits trade with a high degree of correlation to the price of oil. The global oversupply of oil triggered a price correction in the middle of 2014 and high yield energy credit showed an inverse relationship to oil. Toward the end of 2014, OPEC made the decision to continue with their current levels of production, which only accelerated the decline in price and spread widening.
Earlier this year, the spread differential between high yield energy spread and U.S. treasuries widened to 700 basis points, which implied a 10% default rate. Long term default history of the energy sector has been 1.4%, which is below the broader market’s 3.1% rate, even with commodity price volatility.
While the energy sector is the largest single issuer at 15% of the U.S. high yield market, energy bonds have varying levels of sensitivity to commodity prices. The exploration and production sub-sector of energy is most directly sensitive to commodity prices.
Muzinich’s worst case scenario factors in oil prices remaining depressed and sector defaults reaching all time highs. Under this scenario, Muzinich expects the possibility of 100 basis points damage to high yield return across a diversified portfolio.
Energy companies have executed an economic response to lower commodity prices by dropping rig counts and capital expenditures being cut across the board. As they are feeling the impact of falling prices, they have started to access the equity market to improve liquidity. Going forward, Muzinich expects that there will be continued volatility, but an opportunity for those investors that can be opportunistic and patient as the supply/demand imbalance corrects.
Muzinich is currently developing customized Energy portfolios for those insurers that have the flexibility to be opportunistic and take advantage of the market dislocation. To learn more, please speak with your AAM representative.
Employee Spotlight: Joe Borgmann, CPA,
Director of Investment Accounting
Director of Investment Accounting 18 years experience
Joe joined AAM in 2004 to lead the firm’s Investment Accounting department. Joe is a regular speaker and contributor to insurance industry publications, helping insurers to stay current on the constantly shifting landscape of statutory, GAAP, and IFRS accounting. Joe has 18 years of investment accounting experience (11 years at AAM) and is a Principal of the firm.
How did you get into working in Investment Accounting?
When I was with E&Y, I audited several insurance companies. Then after my second year, I transferred to E&Y’s Cayman Islands office and worked mostly on hedge funds and some captive insurers and banks. So, investment accounting for insurance companies was a natural direction for me.
What are some of the key events/issues happing right now?
There are two significant issues starting to get traction at the NAIC: The expansion of the NAIC designations and the investment classification project. Both of these projects are extremely significant, so I am sure they will be ongoing for quite some time.
What’s your favorite thing to do when you’re not at work?
My wife and I have been blessed with three kids. Landon is eight, Anna-Grace is six, and Elizabeth (aka Busy Lizzy) is three. When I am not at work, I am usually spending time with them and enjoying every moment.
What hobbies or interests do you have?
A couple of years ago, a friend talked me into winemaking. We purchased all the necessary items and got grapes shipped in from California. After reading everything that I could about the winemaking process, I thought for sure it would turn-out to be a decent table wine. Unfortunately, I was wrong. I still have all the supplies and I know the kids would enjoy stomping the grapes, so maybe I’ll give it another shot.
What’s the last book you read?
My last book was The Escape, by David Baldacci. It’s about a military investigator, who is investigating his younger brother’s escape from a maximum security military prison and trying to prove his innocence. I enjoy a great thriller.
What’s your favorite vacation place and why?
Growing-up, my family always spent the summers on Table Rock Lake, which is located in the southwest corner of Missouri. It’s a beautiful lake nestled in the Ozark Mountains; very clean and with about 750 miles of shoreline. My parents have since retired there. So, the price is right, the cooking is good and it’s a place where I can truly relax. I also really enjoy waterskiing and find it heavenly to get out on the lake early and ski when the water looks like glass.
What’s one thing people would be surprised to know about you?
As result of my desire to maintain a certain level of respect from my father-in-law, I have accomplished some home and automotive repairs that may be surprising to those who have seen me call for backup to clear a paper jam in the copier.
AAM Thought Leadership Articles
AAM produces a number of Thought Leadership articles throughout the year regarding such topics as sector analysis, market conditions, and investment accounting updates. Below is a list of the Thought Leadership produced recently with direct links to the articles.
Post Election Recap: Assessing the Impact of Tax Reform on Insurance Companies
Budget deficits, the national debt, and a path forward remain divisive issues in US politics. Among the most controversial facets Read more…
Improved Consumer Confidence Bodes Well for Strong Holiday Retail Sales
A brief snowfall on Halloween in Chicago quickly reminded us that the holidays are fast approaching. Pumpkin candy buckets and Read more…
A Detailed Analysis Into the Fundamental Factors Affecting Crude Oil Prices
Excess returns of the energy sector have significantly lagged the investment grade corporate market in 2014 due to the unexpected Read more…
2014 Investment Accounting Changes Every Insurance Investment Officer Needs to Know
Joe Borgmann, CPA, Director of Investment Accounting at AAM reviews significant changes that every investment officer should keep in mind Read more…
Standard and Poor’s Settles Ratings Methodology and Practices Misconduct Charges with the SEC
The Securities and Exchange Commission today announced that they had settled with Standard and Poor’s (S&P) on charges of fraudulent Read more…
Finally…The Year for Higher Rates? AAM’s Investment Outlook
U.S. economic growth for 2015 is expected to improve modestly from last year as consensus forecasts project real GDP will Read more…
AAM in the Community
For the last eight years, AAM has forged a very successful partnership with the United Way. Beyond raising nearly $100,000 in financial support for the organization, AAM has participated in the United Way Volunteerism Program.
Two important United Way community volunteer initiatives this winter included:
- In October 2014, AAM kicked off its annual United Way campaign by partnering with Connections for Abused Women and their Children (CAWC). The organization is committed to ending domestic violence and providing shelter for women and children affected by domestic violence. AAM collected toys, clothing, toiletries, and gift cards for the women and children living in their safe shelter.For Valentine’s Day 2015, AAM donated candy, snacks, games and activities for the children.
- In November 2014, AAM employees packed boxes of non-perishable food items for senior citizens at the Mac Warehouse for Catholic Charities. Twenty-one employees packed over 900 boxes (photos below), bringing the total to over 6,000 boxes packed for senior citizens over the last five year period.
Mike Kelch, Senior Portfolio Manager, lends a helping hand.
First Row: John Olvany, Pat McGeever, Mike Ashely, Joe Borgmann, Brad McDonough, Beth Sanford; Second Row: Ryan O’Connor, Mike McClain, Mark Steiger, Pete Wirtala, Sebastian Bacchus, Neha Patel, Elizabeth Henderson; Third Row: Mike McLaughlin, Mike Kelch, Patryk Carwinski, Eric Pochyla, Matt Bullen, Gary Alvarez
AAM will be attending and/or participating in the following industry conferences.
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Colin Dowdall, CFA, Director of Marketing and Business Development
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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.
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. Registration does not imply a certain level of skill or training. 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. Any opinions and statements contained herein of financial market trends based on market conditions constitute our judgment. This material may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different than that discussed here. The information presented, including any statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Although the assumptions underlying the forward-looking statements that may be contained herein are believed to be reasonable they can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. AAM assumes no duty to provide updates to any analysis contained herein. 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.