Chandler Bond Market Review

Short Maturity Corporate Notes – Worth the Risk?

The US Corporate bond market has rewarded investors over the past few years, and the team at Chandler wanted to take a step back and evaluate the Corporate sector from a quantitative perspective. Broad sector spread differentials between the financial and industrial sectors have dissipated, driven partly by improvement in bank sector balance sheets and the overall trajectory of the US economy. The financial sector is no longer materially dislocated from the industrial sector, a large positive for the economic recovery, as banks are now able to provide disintermediation to lower rated Corporate entities. The dramatic improvement in spreads has come about in the face of a lackluster economic recovery and some investors are starting to question the overall risk and return characteristics of the high quality investment grade market.

Many classes of investors appear to be tactically allocating assets to the short maturity spectrum of the investment grade market in anticipation of the Federal Reserve tightening traditional monetary policy sometime in 2015 or later. The Federal Reserve commenced removing some of the extraordinary accommodation to help stimulate the US economy and is approximately 25% complete with the “tapering” of the asset purchase program. We expect the tapering process to be complete early in the 4th quarter of this year, however, we (and the market) are less certain as to when and to what magnitude traditional monetary policy will be adjusted to be less accommodative. The uncertainty regarding the change to traditional monetary policy is leading investors to gravitate to shorter maturity assets in Chandler’s view.

In order to better ascertain the relative value of short maturity high quality spreads we broke down the sector components of the Barclays 1-5 year Indices between Agency and Credit securities, A rated or better. We also broke down the A or better Credit index into ‘AAA’, ‘AA’, and ‘A’ rated cohorts to better understand the changes that have taken place over the past decade. The data is grouped into pre- and post-crisis periods, and contains a snapshot of the entire period as well, to better understand the potential volatility of spreads and to illustrate past periods when spreads were very low and contained for long stretches of time. We utilized monthly Option Adjusted Spread (OAS) data from the Barclay’s family of indices starting in February 2004 and ending February 2014. The data is displayed in graphical form (below) as well as in a table (back page) to help validate our analysis. The scale on the charts was kept the same in the pre-crisis (February 2004 to July 2007, top two charts) and post-crisis (December 2009 to present, bottom two charts) to better demonstrate some of the relative value differentials between the various credit quality tiers under evaluation. The two middle charts, depicting the entire 10 year spread history, have a scale all their own. The spread widening during the crisis was very severe and unprecedented that it should serve as a deterrent from becoming too complacent regarding the potential risks in all investment grade sectors.

High Quality OAS Spreads

The post-crisis charts effectively illustrate the 1-5 year Agency index has an OAS that is very aggressive. Qualitatively this makes sense to us as both Fannie Mae and Freddie Mac remain under conservatorship and are essentially a liability of the US Treasury Department. Additionally, despite the continued efforts of various constituencies within the US Government, the likelihood of Fannie Mae and Freddie Mac becoming quasi public/private entities again is very low in our estimation. Agency index OAS valuations reflect both the very high credit quality and scarcity value of the sector as both Fannie Mae and Freddie Mac are being forced to shrink as part of the conservatorship agreement.

The 1-5 year Credit A or better index has clearly performed well in the post-crisis period (see charts) and remains more attractively valued than the pre-crisis period, which we view as a positive for the credit sector. The current OAS of 0.44 is the tightest valuation in the post-crisis period but 0.10 wide of the all time tight valuation of 0.34. In light of the demand for spread securities, particularly in shorter maturity assets, as well as the improvement in corporate balance sheets and fundamentals since the financial crisis, we think the overall valuation of the 1-5 Year Credit  A or better index is fair. We are however concerned about the current valuation in the two highest rated cohorts within the 1-5 Year Credit A or better index.

Relative Value Matrix

Focusing on the post-crisis period the ‘AAA’ rated cohort currently has an OAS of 0.11, only 1 basis point away from the all time lowest level of 0.10 and just 0.03 greater than the average Agency OAS. In our estimation, the average spread is too tight and does not provide any cushion for the possibility of deteriorating fundamentals which could lead to OAS widening and subsequent underperformance. The current OAS valuation for the ‘AA’ cohort is also on the expensive side but at least appears to offer investors some form of compensation in excess of the Agency sector with a current OAS of 0.36 versus 0.08 for the Agency sector. The current valuation is the tightest since the post-crisis period but is also 6 bps wider versus the all time OAS tight level of 0.30.

The A rated cohort, with a current valuation of 0.61 OAS appears more appropriate in light of the currently yield starved investing environment and earlier mentioned improvement in corporate fundamentals. Investors need to keep in mind the possibility that some of the credits represented in this group have the potential to improve their underlying credit quality over the investment horizon, potentially providing some form of spread tightening relative to the overall investment universe represented in the graphs and tables. The higher rated cohorts don’t have this opportunity and thus could be looked at as having an extra element of risk as the distribution of the spread movement is skewed to stay the same or move wider as spreads are unlikely to trade at negative spreads versus Treasury notes.

At Chandler, we continuously focus on managing risk on behalf of our clients. A strong investment culture focusing on identifying both improving credits to add to portfolios and deteriorating credits to remove from portfolios is a key prerequisite to utilizing the credit asset class. A well diversified portfolio across sectors, maturities, and credit quality is required in order to navigate the challenging investing environment. For those investors with the risk tolerance to invest in the credit sector, we think the better opportunities exist in ‘A’ rated securities and would urge extra caution when purchasing securities with excellent fundamentals but little spread compensation for the risk of not owning a risk-free Treasury security.

 

– William Dennehy II, CFA
     SVP, Portfolio Manager

 

 

 

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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