Thought Leadership

Corporate Strategy Bulletin – June 2014

June 16, 2014

In this Bulletin: Corporate Bond Outlook

  • Jonathan Lewis, Chief Investment Officer, Managing Partner

Corporate Bond Liquidity Update

  • Brian Meaney, Portfolio Manager

Relative Value in Corporate Sectors

  • Lacey Greenwalt, Portfolio Analyst

Corporate Credit Update

  • Jeff Wimmer, Credit Analyst

Corporate Bond Outlook

  • Jonathan Lewis, Chief Investment Officer, Managing Partner

We maintain a positive outlook for corporate bonds, and maintain an overweight position in the sector in our taxable bond strategies.

  • The muddle-along economic environment has created an ideal environment for corporate bonds.
  • Growth is good enough to sustain healthy corporate earnings, and many companies have their strongest balance sheets in years.
  • This outlook is supported by the minutes of the April FOMC meeting, which suggest that the Fed will be easy for a very long time. Corporates typically perform well when the Fed is accommodative.

While some investors have begun to worry that corporate spreads are very tight to Treasuries and valuations rich, we think it’s important to note that these valuations are actually quite reasonable when we compare them to the corporate spread environment before the financial crisis. As Exhibit 1 shows, though spreads are much tighter than they were in the 2008-2009 period, corporate valuations are comparable to pre-crisis levels. In certain sectors, spreads are actually wide to those levels.

There are reasons both technical and fundamental that may support a tighter spread environment for an extended period of time:

  • Demand for corporate bonds from investors is very high. The Fed’s low rate policy has forced investors to move out of cash into higher yielding assets and many investors have used fixed income ETFs as the investment vehicle to achieve that objective. Exhibit 2 shows the premium/discount cycle of the iShares Corporate Bond ETF (LQD), which demonstrates that investment demand for corporates is so high that retail investors have been willing to pay as much as a 60 basis point premium to the NAV of the fund since the start of the year. Days when the fund has traded at a discount have been rare.
  • The supply/demand relationship between Treasuries and Corporates has changed significantly since the financial crisis – this too favors corporate bonds. Exhibit 3 to the right shows the ratio of Treasury bonds to corporate bonds based on the outstanding size of each market at year-end. The amount of Treasury bonds has risen sharply relative to corporates since the financial crisis – this fact, combined with downgrade of the US Treasury by a major rating agency, also supports a tighter spread environment.

While we are positive on corporate bonds, in this tighter spread environment it is particularly important to monitor the spreads of individual issues and sectors on a rich/cheap basis to protect against spread widening and its impact on performance. As we monitor spread valuations, we also consider how corporates bonds perform on a roll-down basis compared to Treasuries. As shown in Exhibit 4, corporates remain quite favorable to Treasuries when we look at how they perform as they roll down the yield curve. Corporate Bond Liquidity Update

  • Brian Meaney, Portfolio Manager

The size of U.S. Corporate market has grown 60% from 2007 to 2013. The higher supply has not resulted in improved liquidity as measured by Federal Reserve’s dealer inventory stats. However, as we see in Exhibit 5, primary dealers who trade with the Fed report their holdings have declined from $235 billion from October 2007 to about $70 billion today. There are fewer banks than in the past, and recent regulations have caused banks to shift away from market-making activities. This new age of reduced dealer inventories creates both opportunities and risks for investors.

  • From the glass half full perspective, dealer deleveraging was a contributory factor in the historic spread widening that occurred in corporate bonds during the financial crisis. In the aftermath of crisis, and Dodd Frank, dealer levels are now near historic lows. In short, a major seller has been taken out of the market, and the risks of mass dealer liquidations impact market valuations are reduced.
  • This is a longer-term positive for fundamental investors, who invest in corporates based on credit analysis, as short-term technical based dealer behavior may be less influential.

From the glass half empty perspective, this drop in dealer willingness to take risk reduces liquidity for investors wanting to buy and sell corporate bonds in the secondary market.

  • It is ironic that even though there are more corporate bonds than ever, it has become more expensive for investors to transact.

  • Samson mitigates the risk of illiquidity by focusing on the largest bond deals from major companies. While dealer liquidations are no longer a major risk factor for the market, dealers are less willing to hold positions and significant buy-side sales could lead to more spread volatility should the outlook for corporates become negative.

Relative Value in Corporate Sectors

  • Lacey Greenwalt, Portfolio Analyst

As part of our relative value analysis, we look at statistical measures of rich/cheap. We identify sectors that may be valued cheaply from a historical standpoint, and focus on credits with strong fundamentals. In the current environment, we find the energy and utility sectors particularly attractive on a spread basis, and likely beneficiaries of the muddle along economic outlook embraced by our investment committee. Though energy as a sector remains attractively priced from a spread perspective, energy prices themselves have rallied meaningfully this year, which we believe augurs well for the sector. With regard to the utility sector, forward looking market indicators are also positive. Utilities stocks have outperformed the broader markets, credit fundamentals are positive, and we are constructive on the sector. Though certain sectors have become more richly valued on a year-to-date basis, we still favor many high quality credits in these sectors as we view their expected returns to be superior to Treasuries and agencies. Longer-term spread history that includes pre-crisis spread data highlights this point. The Food and Drug Retail sector, for example, currently trades at tight spreads to comparable maturity treasuries, but appears more attractively priced when compared to pre-crisis levels. We believe the spread relationships of this period are more informative as the economy continues to normalize.

Corporate Credit Update

  • Jeff Wimmer, Credit Analyst

We are positive on corporate credit as earnings growth continues and balance sheets remain strong with record cash levels. We feel that this is particularly true for financial companies. We are favorable on that sector as there are clear industry catalysts from higher interest rates, increased commercial and industrial loan demand, and bottoming net interest margin. We remain tepid on the consumer staples sector as weaker emerging market demand and foreign exchange headwinds lowers these companies dollar revenue growth. Merger and acquisition volume has been strong this year, as $1.2 trillion in deals have been announced – an increase of 42% year over year. This is the highest level since 2007, and the third busiest year since 1980. The healthcare and pharmaceuticals sector have had the most activity. While ratings agencies have been more lenient than usual for strategic acquisitions, we are selective in the healthcare space due to debatable synergies, an increase in leverage, and higher execution risks which may result in credit downgrades. Please click on the link below to download the commentary.