Stopping By Woods
Investors sometimes refer to bull markets as “climbing a wall of worry”. Over the last few quarters it seems more like we are passing near a deep and mysterious forest, full of perils that seem to loom, recede, and reappear, seeking to distract us on our investing journey. As we write this, not only is Greece headed into uncharted waters, but Puerto Rico’s governor acknowledged that the Territory cannot pay its debts, the political dysfunction in Illinois is frightening creditors and illuminating Chicago’s unsustainable debt and pension situation, the U.S. Administration’s attempt at rapprochement with Iran is worrying the oil markets, and China’s government and financial sector are intervening to stop a sharp correction in the stock market.

These are worries indeed, but from another angle, there isn’t much new here. Consider each in context: Greece’s inability to pay its debts has been clear for years; Puerto Rico’s unsustainable finances have been obvious for a decade; Illinois last extended payments just a few years ago; The Iran ‘deal’ has been a subject of partisan rancor since last summer; And the fall in China’s stock market is equivalent only to the last few month’s gains. Meanwhile, here in the U.S., employment data has been fairly strong and markets still expect the Fed to raise rates in the next year.

We are particularly bemused by the reaction in China to the stock market slide. Short memories are one thing, but the panic about China’s stock market also demonstrates investor’s asymmetric tolerance for volatility. We don’t remember anyone claiming that the larger rise in China equities from March to June was a crisis, but now we see the government pressing brokers to pool resources and allow investors to use their homes as margin, all to combat the disappearance of a few months’ profits. These policies are a frightening echo of the connection between housing speculation and financial market gains that preceded the U.S. financial crisis.

It has long been our contention that when governments “kicks the can” down the road in the name of calming volatility, it risks bottling up even more chaos for later. So every time Greece and Puerto Rico (and even Illinois) flare up, investors worry that this time it will get out of control. Each round of restructurings is like a turn at Russian Roulette: odds are that any individual chamber is empty, but absent real reform, the game continues and the chances of encountering a bullet approach 100%. It may be Greece’s turn. Since most of Greece’s debt was transferred to central banks after 2011, the debt adjustment losses will now be mutualized across European citizens. Whether Greece exits the Euro or not, Greek citizens that were unable to transfer Euro-denominated wealth abroad will see continued dramatic reductions in income and wealth as economic activity slows further and/or their incomes and bank accounts are potentially redenominated in a devalued currency. These are not happy choices.

We have no first-order exposure to the current crisis areas. We have no Greek or even periphery debt, we have yet to find Chinese debt issuance structurally acceptable to us, and we’ve never purchased a Puerto Rico obligation. We certainly have some credits exposed to the price of oil, and credits operating in economies that would suffer from reduced Chinese demand (Brazil and Chile, particularly).

Of these possibilities, we remain particularly concerned about developments in China, just given the sheer size and global importance of the Chinese economy. It is difficult to know the (slower) rate at which growth is sustainable, and how government intervention in credit and financial bubbles will affect economic behavior. We expect there will be many more rounds of government intervention and, ultimately, slower growth. The pace of that adjustment will have a substantial effect on global markets. Greece, Puerto Rico, and Illinois are more likely to produce temporary opportunities to invest at more attractive prices over the long term.

Rates Volatile, Credit a Headwind

All the sovereign credit headlines have pushed U.S. interest rates off the front page. U.S. Treasury rates rallied through the first quarter (to the dotted line in the accompanying chart) of 2015, but reversed rapidly in the second quarter. We expect volatility in U.S. Treasury rates to remain elevated as we transition back towards a more normal rate environment. While short-term rate changes are not easy to predict, we continue to hold durations fairly short for our rate-hedged portfolios.

Given elevated international macroeconomic uncertainty, the last quarter and the last year have been unfriendly to credit. Bank loans have been the best performing credit sector in our universe, joining Asset-Backed securities (ABS) and Commercial Mortgage-Backed securities (CMBS) as the only credit sectors to produce positive excess returns (i.e. outperforming U.S. Treasuries of similar duration). Investment Grade corporate bonds produced positive total returns over the last year thanks only to falling U.S. Treasury rates through the first quarter. The dominance of rate-related effects is illustrated in the accompanying charts, with the U.S. Treasury rate component of return in red, credit-based excess returns in blue, and the sum, or total return marked with a black diamond.

Unlike the index credit sectors, our own credit portfolios have produced positive excess returns. Thanks to strong security selection, our rate-hedged and core portfolios all have positive returns year-to-date                                                       

Credit Exposures and Opportunities

Municipal Credit

In contrast to Puerto Rico, we do have positions in Chicago and Illinois in our Taxable Bond Portfolios. As our clients well know, if a specific name or region is tarred with a broad brush, we are compelled to look closely at the affected issuance to see if we can find durable issuers or structures. We haven’t yet found any durable debt in Puerto Rico, but Chicago has several bond issuances directly and specifically backed by revenue streams that should protect them from impairment. We also view the State of Illinois as possessing the resources and abilities to repay its debt. Illinois is a poster-child for underfunded pensions, but the size of the problem is manageable in the context of the larger state economy, as opposed to within the Chicago city limits. Much like our earlier investments in Michigan-backed Detroit Public Schools paper, we see exceptional opportunities in the pricing of both Illinois and a handful of Chicago revenue credits. For investors that cannot take advantage of the tax exemption of municipal bonds, the Illinois “Build America Bonds” are particularly attractive.

Corporate Credit

There has been plenty of news for our energy credits in the second quarter, most of it positive. Individual security returns within our energy exposure have been exceptionally volatile, ranging from +16% to -10% for the quarter. Petrobras was not only able to issue the second high yield 100-year bond we can recall (Mexico issued the other), but this new ‘Century bond’ was also four times oversubscribed, allowing the underwriters to reduce the initial yield and double the initial offering size. While we are pleased that Petrobras now enjoys ready market access, we are not sure if the oil exploration and refining business will even exist in 100 years, and wonder what on earth investors in these bonds are thinking (other than the obvious “8.5%!”). Our analyst, Robert Matayev, was correct about a much more important fundamental that many investors overlooked earlier: As the price of oil decreased, Petrobras’ refining margins increased. This caused a $6 billion positive swing in the last quarter’s refining profits. Finally, Petrobras has released its new strategic plan, which reduces capital expenditures dramatically (at last!) and focuses the company’s development strategy on the pre-salt, where the rigs that collateralize our Odebrecht notes are all under long-term contract. There was one piece of negative, and somewhat surprising news – the CEO of Odebrecht S.A. (the parent company of our obligor) was jailed in June as “a preventative measure”. Marcelo Odebrecht was one of the first executives in Brazil to cooperate with authorities as they began to stamp out the graft so commonplace in large public projects in Brazil. We had expected that his early cooperation was a positive, so we are following this with interest. On this news, Odebrecht was the poorest performer among our energy holdings (in fact, among all of our holdings). The collateral securing our Odebrecht bonds is among the youngest in the fleet, fully contracted at below-market rates, and running efficiently. It’s value has been demonstrated repeatedly throughout this turbulence, remaining a crucial backstop to the credit.

While Bank Loans have been the best performing sector over the last year, our loan positions are shrinking. The refinancing environment has been extremely favorable, and loans are repricing at levels we find less and less acceptable. Upgrades have also begun to take away some of our high yield positions. Heinz and Hospira will be upgraded via merger (Kraft and Pfizer, respectively), joining Dell, which achieved its upgrade the less glamorous way – execution.

Structured Products

Securitized products have not completely escaped the volatility in broader credit markets, but strong fundamentals and stable technicals have muted pricing pressure in ABS. Senior tranches of asset-backed transactions widened 5 basis points during the second quarter, but still posted positive quarterly performance due to their short tenor and solid yield. Total issuance for the first half of 2015 is moderately ahead of the 2014 pace.

The bigger story, though, is the continuing compositional shift away from the “traditional” ABS products such as credit card and prime auto ABS, which composed less than 37% of first-half issuance, towards non-traditional products. Eighteen new issuers entered ABS markets in the first half, more than in all of 2014. We continue to identify attractive opportunities among those issuers who may be new to ABS markets, but have a successful management track record over multiple business cycles. For example, in June we participated in ECAF 2015-1A, a $1.1 billion transaction secured by 49 commercial aircraft, on lease to a geographically diverse set of airlines. Babcock and Brown, a 25-year veteran aviation lessor, will manage all the collateral in this securitization.

CMBS also benefited from strong fundamental performance, as steady U.S. growth and improving labor markets drove a 6.8% rise in average commercial property valuations in the first half of 2015. June multi-borrower conduit supply was unusually high at $9 billion, double the pace of prior months, and spreads on senior tranches leaked 5 basis points wider. We have been very patient this year in anticipation of such an opportunity driven by heavy supply, and participated in two of the highest credit quality conduit issues this year, at spreads near 2015 wides.

GE’s jaw-dropping announcement in April of its plan to sell the GE Capital finance operations has two big implications for structured products markets. First, a large portion of the $200 billion of loan and hard assets that GE is planning to sell is likely to be securitized by the new owners. CMBS issuer Blackstone’s $13 billion purchase of GE’s commercial real estate book and ABS issuer Element Financial’s $7 billion purchase of GE’s commercial truck fleet business suggest the potential for $100 billion in new securitization volume from the spin-off. Second, a primary motivation for GE is to lose its Systemically Important Financial Institution (SIFI) status along with all of its encumbering regulation. With similar objectives, large deposit-funded U.S. banks continue to shed lending businesses to ABS and CMBS issuers, a major factor in the growth of these securitized markets.

Our comments on the agency MBS market will be as small as our exposure. Compensation is modest, and duration extension risks are large. Even the high-coupon issues we have liked in the past are now far less attractive. We own almost nothing here.


Of the various global concerns listed above, a change in China’s growth trajectory is the one most likely to change the fundamentals of our credit environment. But markets may (over-)react to any of them. While we choose to remember and cite Robert Frost below, others may reference Game of Thrones: “Winter is Coming”. As you can see from the credit exposure discussion above, we stick to our value- oriented mission - to invest in durable credits at attractive yields when we find them. Over the long term, your habits become your character.

The woods are lovely, dark and deep, 

But I have promises to keep, 

And miles to go before I sleep, 

And miles to go before I sleep.

                        Robert Frost,
“Stopping by Woods on a Snowy Evening”


Andrew P. Hofer

Head of Taxable Portfolio Management

Neil Hohmann, PhD

Head of Structured Products Research and Strategy