Staying Focused on the Fundamentals

It’s been yet another mixed quarter for credit, with investors unsure how to treat the new lower prices of oil and other commodities, new quantitative easing in Europe, and a new, controversial, diplomatic opening to Iran amidst rising instability in the Middle East. If history is any guide, such an unsettled environment should produce interesting opportunities for those who keep their heads and focus on the fundamentals.

A foundation of the “Efficient Market Hypothesis” is that equity prices are determined by the discounted value of future streams of dividends. Economics Nobel Laureate Robert Shiller challenged this assertion comparing a time series of discounted future dividends, computed with perfect foresight, to the corresponding time series of actual stock prices. In a simple, yet remarkably convincing way, he shows that the volatility of observed stock prices is much higher than can be explained by actual known fundamentals, as described by fluctuations of discounted dividends.1 In the fixed income markets, there exists an equivalent result that has been internalized in our investment process. Credit spreads “should” be determined by the default risk embedded in non-Treasury issuers; however, as the chart below shows, the level of credit spreads and their volatility greatly exceed the compensation required to cover default losses. This “credit spread puzzle” does not only manifest at the level of market averages but at the security level as well. Indeed, when spreads attached to an issuer we consider strong seem too high and volatile, we are willing to challenge the market’s view with our own.

The proper reaction for rational investors, as Shiller points out, is to form expectations carefully and not revise them so quickly. The real world unfolds less dramatically than market price reactions. As you think about the price fluctuations over the past 12 months, particularly in interest rates and energy prices, it pays to bear this in mind.

Long U.S. Treasury rates rallied persistently in the first quarter, with 5-year maturity yields down 27 basis points to 1.37% and 10-year maturity rates down 24 basis points to 1.93%. We continue to believe that U.S. Treasury rates offer little in the way of downside protection in a normalizing rate environment. In our view, the continuing rally reflects a global dearth of high quality yields. It is staggering to us to see U.S. sovereign yields, from 3 to 30 years, not only higher than Japan and German sovereign bonds, but 50 -140 basis points higher than Euro-denominated sovereign issuance from France, Italy, Ireland, and Spain! These new quantitatively-eased sovereign rates may keep a lid on long U.S. Treasury yields for some time, but even steady progress toward Fed-engineered rate normalization can eat into bond returns significantly.

It’s been a tough 12 months for Corporate credit, the first bear market in credit since 2011. Eight of the last 12 months produced negative returns to credit, and over the last 12 months, Citibank’s rate-hedged investment grade Corporate bond index2 returned minus 1.6%. The comparable High Yield index3 lost 3.0%. In such a relentlessly negative context, we are pleased that our hedged credit portfolios are up slightly over the last year. Flights to quality are a huge headwind for our credit-oriented bias, and we are pleased to have limited the downside of a difficult market.

If you were to look at our holdings as compared to the widely-used Barclays Capital Aggregate Index, our portfolios are modestly underweight corporates, while substantially overweight credit in general, thanks to large positions in Asset-Backed Securities (ABS) and Commercial Mortgage-Backed Securities (CMBS). We hold substantially less in U.S. Treasuries and Agencies than the Aggregate Index, and would show up as dramatically underweight Agency Mortgage-Backed Securities (MBS), which we view as ridiculously overbought. This has been our bottom-up positioning for some time, although our Corporate bond exposure was quite a bit higher two years ago, when valuations were more attractive. Starting in 2013, we found good values in CMBS even as our Corporate bond investments decreased. Our overall exposure to credit vs. U.S. Treasuries has detracted from returns over the last year, but our exposure to better-performing areas within the credit universe has helped cushion the downside. We continue to believe that credit oriented strategies will outperform as long as we stick to our valuation discipline for each investment.     

Within the first quarter credit performance was erratic, with excess credit returns versus equal duration U.S. Treasuries quite negative for January, positive for February, and mixed in March. Cumulatively over the quarter, investment grade credit produced excess returns ranging from negative
18 basis points for triple-A credit up to positive 18-21 basis points for triple-B and single-A credit. CMBS outperformed Corporate bonds again, with excess returns of 40 basis points, High Yield bonds produced 1% excess returns, and Loans topped the charts again with over 2% excess returns (more on that below). All of High Yield’s returns came in the higher double-B and single-B grades, plus loans, where all of our below investment grade credits reside.

In general, our Core and credit-oriented accounts underperformed in January, and despite a strong February and March we are still behind benchmarks slightly for the quarter.

All these gyrations leave investment grade and High Yield spreads 30-100 basis points wider, respectively, than they were in June of 2014, when the credit rally came to an end. ABS and CMBS held in better over the same period, with spreads widening only 10 basis points. Despite credit’s persistent lag, pricing hasn’t moved enough, outside of energy and commodities, to make many Corporate obligations newly attractive. In 2014 we had difficulty finding good value in Corporate bonds (Both investment grade and High Yield), but were able to find some bargains in ABS, CMBS, and Loans. While these markets still offer better pricing, we find ourselves with fewer opportunities at our “Buy” levels. Most of our investments are moving around in our “Hold” zone, not cheap enough to buy more, but not rich enough to sell completely.

Loans topped the sector excess return charts at 2.13% for the quarter. Unfortunately, Loans have become scarce and less attractive, thanks largely to a perfect storm of new and pending regulation, private equity competition and improving fundamentals. In the first quarter of this year, banks began to limit leveraged lending above a debt multiple of 6 times EBITDA. This was exacerbated by fierce competition among private equity investors, driving both valuation multiples and debt leverage higher. Meanwhile, some of the biggest loan issuers, such as Dell and Heinz, are poised for upgrade to investment grade, hastening their call over the coming year. Finally, Collateralized Loan Obligation (CLO) managers are facing expensive new capital regulations next year, releasing a torrent of new demand as CLO managers furiously push product out the door. This scarcity led to zero new loan additions to BBH portfolios in the first quarter and only one acquisition bridge facility (SS&C Technologies). Needless to say, our loans have more than held their value through the spread gyrations of the last three quarters, and they continue to provide an attractive spread plus an above-market LIBOR floor rate.

In other activity in the first quarter, we built positions in Franklin Square (A Business Development Company), Royalty Pharma (pharmaceutical royalties), Pfizer, Scentre Group (a REIT), Heinz, Selective Income Realty (another REIT), Scripps Interactive (media) , Credit Acceptance Corp (consumer lending), Actavis (Pharmaceuticals) Renaissance Reinsurance, and Canadian, New Zealand, and Australian banks. We reduced or sold out positions in Apple, General Motors, “Blue Wing” (a CVS lease securitization), One Beacon, Moody’s, Hospira, and Medtronic. Spreads in these dispositions were, on average, about two-thirds of purchase levels. Finally, we took advantage of weakness in Fairfax Financial bonds to extend our holdings.

Fairfax, Franklin Square, Royalty Pharma, and Selective Income REIT all stand out as triple-B rated bonds (some deserve higher ratings, in our view) with spreads ranging from 215-352 basis points, at a time when market-wide intermediate triple-B and double-B spreads average about 140 and 275 basis points, respectively.

On the structured front, we exited over a dozen positions for valuation reasons. We sold CMBS debt secured by the Ala Moana Mall in Honolulu, Hawaii, where spreads have benefited from a recent partial sale of the property that valued it at twice the 2012 level. We also reduced positions in seasoned Vitality Re insurance-linked notes and ABS secured by drug royalty streams, both of which have tightened substantially from purchase.

There have been several attractive purchase opportunities in the first quarter. In late January, Global Container issued ABS notes and One Main launched a personal consumer loan ABS transaction, both with note spreads over 300 basis points to U.S. Treasuries. We also participated in a two-year CMBS transaction, amply secured by a diverse portfolio of extended-stay Hyatt hotel properties.

Positive U.S. real wage growth and declining unemployment underpin the continued strong credit performance in consumer and commercial ABS collateral, tempered only by regulatory scrutiny in certain products. At low current rates, CMBS enjoys an unusually fertile refinancing environment, resulting in the highest rate of observed loan paydown since 2008, swift credit improvements in existing notes, and a burst of new bond supply.

Both our focus on valuation and our ability to move across sectors into structured and municipal credit have helped us protect downside in our client portfolios this past quarter. The continuing global search for yield is likely to pose further challenges for us in the coming quarters, and our approach will require patience and discipline. Nonetheless, we are confident that taking the long view and avoiding overreactions to today’s news continues to be the path to better fixed income investing.

Although oil industry credits make up only a small percentage of BBH portfolios, we continue to closely scrutinize both our holdings and potential opportunities. Oil prices are low and will certainly impact energy companies’ default risk, although many are hedged through mid-2015. But high yield energy spreads widened through mid-December and then settled down, even as the price of oil continued to drop. As oil prices retested their January lows in March, spreads remained stable.

The price action drowns the plodding pace of actual news on our holdings:

Petrobras has reorganized their board of directors, verifying the truism we offered last quarter about government scandals necessitating people-shuffling. The company has also obtained preliminary approval from Brazilian Securities Regulators for its proposed methodology of financial re-statement. We continue to believe that Petrobras will release its financial information before June, to the distinct relief of the company’s investors. Both Petrobras and Odebrecht bonds have rallied slightly from their January lows.

Pemex cancelled orders for new, uncontracted equipment and terminated or renegotiated expiring contracts on its very oldest equipment (from the 1970s). This news fell hard on Oro Negro, which operates several rigs for Pemex and is slated to take delivery of two more. Our high yield-eligible accounts own an Oro Negro bond collateralized by the very newest equipment, fully contracted and operational. The primary unknown is how Oro Negro will deal with its delivery pipeline and the influence that is likely to have on its continuing operations. Yet like Odebrecht, Oro Negro bonds have rallied slightly off their January lows.

Management of our energy-related credits have enhanced their communication to investors, and we’ve been impressed with the aggressive cost-containment efforts and capital expenditure cuts they have put in place to deal with potentially tough times ahead. For the most part, the effects of lower oil prices and curtailed exploration won’t show up in company financials until at least mid-2015, so it is good to see management adapt ahead of time.

In sum, the plunge in oil prices over the last six months has been accompanied by great volatility in energy credit pricing, but with little fundamental news that would cause a significant revision in our credit views. It’s another potent example for Mr. Shiller. 

1 A more detailed analysis and discussion of these results is the subject of a forthcoming BBH commentary.

2 The Citi Corporate Investment Grade (Treasury Rate-Hedged) Index

3 The Citi High Yield (Treasury Rate-Hedged) Index