Chandler Bond Market Review

Corporate Credit Overview

During 2011, investment grade option adjusted credit spreads (OAS) widened approximately 90 basis points on average.  During the first two months of this year, investment grade OAS, tightened approximately 50 basis points, to an average OAS of about 200. This level is meaningfully higher than the 10-year median investment grade corporate OAS of approximately 150.  Although the 10-year data set includes the financial crisis, when corporate OAS rose to unusually high levels, we believe current corporate bond valuations remain attractive.

Credit OAS Spreads We believe the overall credit cycle is favorable, driven by improving domestic economic activity.  During 4Q 2011, the U.S. GDP grew by 3.0%.  This year, the consensus GDP forecast calls for about 2.2% growth.  We are positive on the domestic economy and believe the ongoing recovery in consumer demand will continue to benefit corporate earnings and credit trends.  However, we anticipate that ongoing turmoil in Europe will lead to continued volatility in the financial markets.

Fourth Quarter Earnings Review
Fourth quarter earnings season was generally better than expected.  On average, companies in the S&P 500 reported nearly 5% quarterly earnings growth on a year-over-year basis.  Average EPS results were about 3% better than expected, with 320 companies in the S&P 500 posting upside earnings surprises.

In the consumer sector, higher-end retailers continued to outperform mid- and lower-tier retailers during the holiday season.  In the food and grocery sectors, price increases helped drive revenue growth in the fourth quarter, though earnings continued to be pressured by high input costs.  High energy and commodities prices were also a headwind to some industrial companies.  Meanwhile, several oil and gas companies reported strong revenue growth, driven by increased volume and higher pricing, though the higher prices were a hindrance to refining margins.  Earnings in the technology sector were mixed with results for hardware companies significantly outpacing results from semiconductor, software, and services companies, on average.

During the fourth quarter, the financial sector faced a challenging environment of low interest rates, slow economic growth, and new regulations.  Banks with exposure to investment banking and trading revenues were negatively impacted in the quarter by client risk reduction and lower trading volumes.  Meanwhile, banks with less international exposure and larger commercial lending activity performed better.  Some banks did see positive growth in the quarter, and credit quality trends continued to show modest improvement.  Overall, earnings results in the financial sector were mixed.  Expectations were generally low prior to the earnings season, helping some banks post better than expected results.  Looking ahead, several banks plan to reduce expenses through layoffs.  Increased regulation is another obstacle for bank earnings.  Yet, stricter capital requirements and increased oversight has generally been beneficial to credit quality.  In summary, the financial sector continues to look attractively priced relative to the overall corporate bond market.

Earnings Outlook
Few companies raised their earnings guidance for the year during fourth quarter earnings season.  We expect first quarter earnings to show year-over-year growth on average, and to be in-line or better than analysts’ consensus views.  Earnings results in the banking sector may be more favorable, as trading volumes seem to have improved during the first quarter vs. 4Q11.  Some companies may have also benefitted in the latest quarter from recent easing in non-energy commodities prices.  Notably, over the past few quarters, the magnitude of overall upside earnings surprises declined, and we expect this trend will continue in the first quarter. We anticipate companies with significant international exposure to remain cautious, in light of uncertainties about global growth (Europe and China in particular).  While companies with significant business will benefit from ongoing improvement in the U.S. economy.   We also expect in many cases, strategic deployment of capital (via share repurchases and acquisitions) will help drive earnings growth, as several companies have recently used cash to buy back shares.

Looking further ahead, global event risk, employment trends, and oil prices are likely to have an important impact on corporate credit throughout the remainder of the year.  These are just a few of the key data points we will be watching closely.

Global Event Risk.  The European economy remains under stress and market participants continue to be concerned about global growth trends. We anticipate ongoing turmoil in Europe will continue to create volatility in the global financial markets over the near- to intermediate-term.

Furthermore, exogenous shocks to the U.S. economy, such as an unexpected escalation of the fiscal crisis in Europe or heightened Iranian tensions, could have a meaningful impact on the financial markets and credit spreads.

Employment.  U.S. unemployment also continues to be one of the most closely watched economic data points.  The unemployment rate is currently 8.3%, which remains high but is down from the recent recession peak of 10.1% during the third quarter of 2009.  According to Bloomberg data, market participants expect a slow decline in the unemployment rate over the next year and are calling for a rate of 7.8% by the second quarter of 2013.  We expect an improving labor market will help drive slow and steady demand and corporate earnings growth, which will continue to support corporate credit quality.

Oil Prices.  Rising oil prices could be a hindrance to corporate earnings over the next year.  According to the Energy Information Administration’s Short-Term Energy Outlook as of March 6th, the price of regular-grade motor gasoline is expected to average $3.79 per gallon in 2012, compared with $3.53 cents per gallon last year.  The EIA recently raised its forecasted price of West Texas Intermediate (WTI) crude oil by $5 per barrel to an average of about $106 per barrel in 2012, $11 per barrel higher than the average price last year.  Supply disruptions in the Middle East and Africa contributed to a significant increase in world crude oil prices during February.  Although we are not forecasting a significant increase in the price of crude oil, we believe a rise in prices to the $130-$150 per barrel range would begin to put pressure on consumer spending levels and the overall domestic economy.

Conclusion
Overall, we believe the outlook for corporate credit remains favorable this year.  Given our expectation for volatility in the financial markets, we believe the investment grade corporate bond sector provides an attractive risk/reward profile.  Though the pace of earnings growth and corporate credit rating upgrades has slowed, in light of ongoing economic uncertainty and market volatility, we remain constructive on corporate earnings and expect the overall economy will continue to grow.

– Shelly Henbest

VP, Credit Analyst

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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