March 2019

Now is the Time to Reduce BBB Credit Risk to Protect Against Principle Loss

Posted on March 18, 2019June 6, 2019 by Sage Advisory

by Jeffrey Timlin

Due to an extremely strong technical environment, municipal yields have experienced a significant decline from the highs of 2018. In addition, credit spreads have tightened to historic lows and offer limited income reward relative to the risk of principal loss. A powerful portfolio management tool that Sage utilizes to optimize risk and reward characteristics is spread valuation analysis. In a historically wide spread environment, Sage would be allocating a larger percentage of the portfolio to lower-rated credits, due to the advantageous income environment. Alternatively, when spreads are near their historic low, Sage will reduce exposure to lower-rated credits to lock in positive returns as well as protect against principal loss.

As show in the chart, the additional spread that municipal investors are offered for owning BBB-rated bonds over Single A-rated bonds is currently 70 bps. Although this may seem attractive from a yield/income perspective, the probability of principle loss remains elevated.

Source: Bloomberg

As an example, let’s take a generic BBB-rated bond with a five-year maturity, a 5.00% coupon and a four-year duration. If BBB spreads quickly revert to the 94-basis point average (shown in gray), the principle loss relative to a comparable A-rated bond would almost be 1.00%. However, if BBB bonds trade back towards the upper end of their historic range (127 bps shown in red), the principle loss under this scenario would be approximately 2.25%. For an investor looking to reduce credit risk and who can accept a slight-to-modest reduction in income, reducing exposure to BBB bonds and swapping into higher-rated credits seems like an advantageous tactical trade until the technical environment normalizes.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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Putting Trade into Context: Sage’s Outlook on Emerging Markets

Posted on March 15, 2019March 15, 2019 by Sage Advisory

For over a year, U.S.-China trade tensions have seized investor sentiment and dominated headlines. While tariffs and a potential resolution to the current episode are important for near-term price action, it’s only one piece of the puzzle. At Sage, we take a broader view on China and trade to determine our outlook for Asia and its effect on emerging markets (EM).

The fundamental issue facing global growth is that the source of China’s economic growth is changing. The country is shifting its growth model from one of exports and fixed investment spending to consumption-led growth. Officials have attempted to rein in China’s debt levels from the high credit growth of the past 15 years, which should result in a lower, but sustainable rate of growth. U.S. exports are a relatively small contribution to Chinese GDP, and the risk of trade tensions has been more about how it could affect business and investor sentiment than the impact on economic growth. The threat of tariffs was a catalyst for last year’s EM selloff, but those risks have been mitigated given a potential trade agreement between the U.S. and China in the coming months.

When we look past trade tensions, the underlying issue is that the Chinese economy is in a material slowdown. The chart below shows global manufacturing activity as measured by the Purchasing Managers’ Index, a common leading economic indicator. Chinese manufacturing activity has slowed to a level that indicates an economic contraction.

Chinese policymakers have responded with fiscal stimulus but have yet to introduce a liquidity injection to boost the property sector, which was China’s playbook for 2016. While the recent stimulus measures will help, its “impulse,” the effect that it will have on the Chinese economy, may not materialize for six or more months.

China is a huge trading partner to other EM countries, such as Taiwan and Korea, and recent figures from those countries have shown the magnitude of the Chinese slowdown.

In addition, commodity exporters, such as Chile, Australia, South Africa, and Brazil, have seen exports decline in recent months. These export numbers are a bellwether to growth in Asia and have the potential to hurt investor sentiment for EM assets.

Given recent strength in EM equities, particularly China, we have decided to underweight emerging markets throughout our equities, fixed income, and asset allocation strategies. The risk to this view is twofold: 1) flows moving into China due to index inclusion (MSCI) and investor demand, and 2) the economy responding positively to recent stimulus or a trade agreement in the near term (0-6 months). Ultimately, we believe these outcomes are improbable given the rapid buildup of flows and the current extreme positive sentiment surrounding EM assets.

The source for both charts are Bloomberg and Sage, as of 3/13/19.

A Reason to Love the MTA

Posted on March 7, 2019 by Sage Advisory

Due in part to ongoing fiscal challenges, New York’s Metropolitan Transportation Authority (MTA) bonds are currently trading at attractive levels. At 55 bps over comparable AAA bonds, 10-year MTA bonds rated A1 by Moody’s offers investors an opportunity to pick up some additional yield without significant credit risk.

As one the oldest and largest transportation networks in the U.S., the authority remains a vital part of New York’s infrastructure and an essential component of commuting for New York, New Jersey, and Connecticut residents. Despite structural deficiencies, Governor Andrew Cuomo, Mayor Bill de Blasio, and many other local leaders are heavily invested in the ongoing success of the MTA. A recent 10-Point Plan to transform and fund the MTA has significant support from both parties. For those who can handle modest credit risk and a bit of spread volatility, MTA bonds offer a good entry point.

As shown below, by selling out of 10 Yr AAA Georgia State GOs (cusip 373385CN) at a 2.17% yield and purchasing 10 Yr A1 MTAs (cusip 59261APZ) at a 2.72% yield, an investor can capture 55 bps of additional income with the same duration/interest rate risk.

Consumer Staples is No Longer a Safe Harbor for Bond Investors

Posted on March 6, 2019March 6, 2019 by Sage Advisory

Not so long ago, Consumer Staples was one of the safest sectors for corporate bond investors. The sector was filled with companies that were known for steady growth and strong margins. They produced items that consumers wanted no matter the state of the economy, including cigarettes, beer, and classic food items like soup, pretzels, and cookies. The sector may not have always been the most cutting-edge, but investors could count on the issuers in the Consumer Staples sector to deliver consistent cash flows that made buying their debt relatively less risky. Secular declines in demand for some of these products, combined with more aggressive financial policies spurred by a wave of consolidation have conspired to destroy this narrative. Investors have taken notice. Once one of the “tighter” trading sectors of the corporate bond market, Consumer Staples companies now have spreads that are in line or, in many cases, even wider than other companies in traditionally more volatile sectors, such as Energy and Technology.

The two major phenomena that have pushed spreads wider in this sector are, of course, related: waning product demand and heightened M&A activity. Health awareness has contributed to slowing sales growth in alcohol, cigarettes, and sugary soft drinks. Sales growth has declined significantly for some companies, forcing many corporate management teams to reevaluate their options for producing the profit growth that equity investors demand.

To increase profits, one option that has become increasingly popular with the C-suite executives of these companies is leveraging M&A transactions. Companies have looked to buy smaller competitors with faster-growing products or combined with similarly-sized peers, adding debt on top of the balance sheet while trying to cut costs via elimination of redundancies. These efforts have had mixed results at best, and at worst have taken long-time blue-chip debt issuers from the being considered stable investment grade outfits to the precipice of junk bond territory.

A high-profile example of this type of failure is the combination of Kraft Foods and H.J. Heinz Co. into The Kraft Heinz Company (KHC). Since the leveraged merger took place in 2015, the combined company’s stock has lost 50% of its value and the entity’s bond ratings have sunken to low BBB, one step away from a junk rating. The deal had the backing of an impressive roster of investors, including Warren Buffett, who believed in the long-term demand for the products they sold and the company’s ability to cut costs and drive cash flow growth enough to trim the large debt burden created by the merger.

Sage follows a universe of benchmark issuers within the Consumer Staples space that echoes this story. Many issuers are carrying significantly larger debt balances while seeing slowing top-line revenue growth. The group has seen average leverage increase from 2.5x in 2015, to 3.2x currently, especially significant given that traditionally the 3x leverage level was a considered a key guidepost for the difference between an investment grade and a high-yield rating from Moody’s or S&P.

At Sage, we have become less sanguine on the prospects for the Consumer Staples sector at large, and within the sector we prefer lower-risk credits that have avoided the temptation to issue excessive debt for mergers designed to spur sales growth. Clorox (CLX) and Colgate-Palmolive (CL) exemplify this discipline, while companies such as Kraft-Heinz, Campbell Soup Co. (CPB), and Anheuser-Busch InBev (BUD) have all the characteristics we’d prefer to avoid.

The source on all charts is Bloomberg.