Quantitative Squeezing

Our Strategies and accounts produced strong absolute and relative returns in the third quarter, as credit markets rallied for another quarter. Markets have thoroughly shaken off the gloom that set in over the prior seven quarters. Among the positions that performed the best:

- Corporate bonds and loans in the “split-rated” range (BBB- to BB+)

- Consumer Finance and Aviation Asset-Backed Securities (ABS)

- Energy, Resources, Pipeline, and Generation companies that lagged in 2015

- Single-A and triple-B rated Commercial Mortgage-Backed Securities (CMBS) positions accumulated over 2015 and early 2016

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We’ve discussed most of these sectors in the past few Strategy Updates, both as sources of opportunity and, around year-end 2015, sources of underperformance. We are particularly gratified to see the large position we accumulated in CMBS and Power Generation contribute positively to performance, along with rebounding Energy and Resources exposures. The Bank positions we described in our last Strategy Update were also initiated at good entry points.

We continue to find value in CMBS and the less traditional sectors of the ABS market, while Corporate spreads tighten further and are now reaching overvalued levels. Both of these changes have been highly visible to our investors. In the midst of this positive credit market, however, the yield curve and money markets have also reconfigured and created some new opportunities, which we discuss herein.

U.S. Credit Markets Benefit from Quantitative Squeezing

The theory behind Quantitative Easing (“QE”) is that when a government buys bond issuance at the safer end of the credit spectrum, the liquidity created by bond purchases will flow into more risky and growth-oriented funding channels – bank credit, new business investment, etc. One unintended effect, however, is that investors squeezed out of the targeted sectors move into overseas markets. U.S. credit markets have been beneficiaries of massive QE abroad.

We pointed out before that European QE is absorbing the entire supply of investment grade credit in Europe and driving more investors West. We now have additional pressure from Japan: The Japan Central Bank announced in September that they would be targeting a yield of zero on 10-year government bonds, slightly higher than the yield at the time. This marks a change in policy from a fixed amount of quantitative easing, like the U.S. and Europe, to a price cap or peg, implying the Bank will buy or sell whatever quantity is necessary to stabilize the yield. While buyers of Japanese Government 10-years are used to zero or negative yield, the Central Bank will now fight, with all its balance sheet resources to peg the yield. It is a reality that negative yield bonds only attract buyers when price appreciation is available. Otherwise, they will move in search of better returns. The cost of a short-term hedge of Yen against U.S. dollars hovers at around 0.63%, while the 10-year U.S. Treasury yield is 1.7% higher than the Japanese 10-year, now pegged at 0%. Yen-based investors can make 1% in the U.S. without credit risk, and 1% plus today’s credit spreads looks more attractive to Japanese investors than it does to most U.S. dollar-based investors.

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The flow of funds into the U.S. dollar markets is compressing market differentials that were quite large just a few months ago. We look at U.S. credit conditions that are fundamentally not very different from this last February, and we are astonished at some of the valuation changes over the intervening months. One dramatic example is Avon. Avon’s 2023 maturity, bearing a 5% coupon, traded as low as $52 in February, two months after they announced a $605 million equity investment by Cerberus. We viewed this investment as a major fundamental improvement for Avon’s fortunes, but since then, very little in terms of the long-term story for Avon has changed. As we write this, Avon ’23 bonds trade just under $90. While we thought these bonds were badly undervalued in February, it’s still stunning to look at the range of valuations the market has put on basically the same credit proposition over seven months.

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Valuations are compressed throughout the Corporate universe, with only 28% of the Corporate universe trading at valuations we consider attractive, compared to 63% back in February. Except for a few pockets of value, our purchases of Corporates have slowed down dramatically. When a bond hits our “sell” valuation level (e.g. no longer a margin of safety), we eliminate the position. In longer Corporate bonds, this has been happening frequently, more frequently than we find new purchases. Our exposure in Corporate bonds has decreased as a result, and our account reserves (cash and Treasuries) have crept upwards.

Another Historic Change In the Yield Curve

The yield curve (from 2-10 years) has flattened dramatically since 2014, reaching post-crisis lows, reducing the “roll-down” return of holding bonds, and making longer bond investments more risky. Along with this change in U.S. Treasury note yields, we’ve reached a five-year high in the three-month London Interbank offering rate (LIBOR) at about 0.85%.

Why is this happening? It’s the fallout from Money Market reform. The Securities and Exchange Commission (SEC) has acted to restrict the types of funds that can use a fixed $1 Net Asset Value (“NAV”). Money Market Funds have either had to become pure retail funds (with no institutional customers) or become Government Funds to preserve the fixed NAV. This change has resulted in almost $800 billion of Money Market Fund assets converted or moving into the “Government” category year-to-date. Government Funds cannot buy Eurodollar time deposits or other LIBOR-based credit instruments. This massive withdrawal of buyers from the Non-Government Money Markets has driven LIBOR higher.

As a result, LIBOR-based instruments have become a new pocket of attractive valuation in an otherwise overvalued Corporate credit market. Some of the more interesting opportunities we’ve seen at quarter-end include a Verizon senior loan, maturing in July 2019, trading at par and paying 3-month LIBOR + 125 basis points (bps) = 2.1%. This compensation is 50 to 80 bps above the current yields of their other senior unsecured fixed notes maturing later in 2019. We’ve also seen LIBOR-based floating-rate Municipal obligations trading higher than U.S. Treasuries, as well as a large supply of bank debt in short maturities, as banks rush to replace their time deposit funding. Short-duration ABS also benefits from a higher swap rate at the short maturities. We’ve recently added 1.7 year triple-A rated small ticket equipment ABS at yields near 2.2%.

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Commercial Mortgage-Backed Securities

CMBS remain among the better opportunities in fixed income right now. The sector is not without concerns, but for certain bonds we think market valuations are simply too pessimistic.

It is possible, still, to earn equity-like returns at the triple-B level (but expect High Yield levels of volatility). The sector is suffering from a supply gut, as a huge concentration of deals underwritten in the 2005-07 timeframe make their way through refinancing. Hedge Funds were squeezed out of CMBS early this year, and have yet to return. Worries about store closures and mall foot-traffic and rising interest rates overhang today’s valuations. Finally, new risk retention rules go into effect on Christmas Eve of this year. We see firming occupancies in the upper-tier office, hotel, and retail properties, and many CMBS deals, particularly single-borrower transactions, that are underwritten to conservative loan-to-value (“LTV”) levels. Our approach is to look at a stress scenario for the underlying loans, and assess their LTVs under those conditions, looking for transactions that are likely to be able to refinance even if the economy or real estate turns southward.

Asset-Backed Securities

All parts of the ABS market dramatically outperformed when other credit products were underperforming in 2014 and 2015. Our ABS holdings include many collateral classes such as Aviation, Consumer Finance, Equipment, Rental Fleets, Floorplan Loans, and even Drug Royalties. These securities have generated much higher returns than the ABS indexes, which are made up of the more traditional auto loans and credit cards and produced mediocre returns year-to-date. Our portfolios remain heavily invested in diverse sectors of the ABS market and continue to benefit from the higher yields on offer.

Agency Mortgage-Backed Securities Lag Again

If you’ve spent any time with us over the last few years, you know that we have seen no value in Agency Mortgage-Backed Securities (“MBS”) for several years now. Returns in the sector have borne this out. It isn’t surprising that MBS lagged credit sectors over the last five years during periods when spreads tightened, but MBS underperformed U.S. Treasuries from late 2014 to early 2016, while credit did poorly (as shown in the chart on the following page). Our positioning here has not changed – this sector does not offer investors enough extra yield to compensate for potential rate volatility.

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Alas, we are hard to please. While we are happy to see the June 2014 – February 2016 credit bear market recede into the rear view mirror, we are already nostalgic for the credit opportunities it brought us. We are also a bit nervous about the frothy competition for spread product brought on by “Quantitative Squeezing”. There is little point in trying to time these cycles, which is why valuations will remain our guide.

Sincerely,

Andrew P. Hofer
Portfolio Co-Manager

Neil Hohmann, PhD
Portfolio Co-Manager