1. 1
Broad, undifferentiated selling in U.S. credit has continued in the third quarter, as the sector
underperformed Treasuries by 0.53%, or 53 basis points (bps), in July and another 74 bps
through August 21. We believe spread widening has been the result of three key factors:
1) Fears over a hard landing in China
2) Unrelenting new issue supply in an illiquid summer
3) Escalation of oil price declines and supply fears
Lock-step spread widening across nearly all industries and among issuers with very different
fundamental characteristics are the key symptoms of these conditions. Of roughly 30 Barclays
corporate industries, only two posted positive excess returns versus risk-free rates in July.
When the market temporarily ceases to value the nuances of pricing risk, it can result in short
term mispricing at the issuer, term structure and sector level. While painful in the short term,
these mispricings offer an accompanying opportunity to seek particularly dislocated securities
or market segments and progressively position them for a return to rationality.
What has driven the recent credit performance?
While oil price declines appeared to take center stage earlier this year, as it had in the fourth
quarter of 2014, the significant underperformance of the Metals and Mining sector this year
suggests that fear of a hard landing in China has been the dominant factor driving credit spreads.
Energy is an input to the other commodities producers and, all else equal, should generally
be a positive for profitability when prices decline. If energy supply/demand dynamics were
the sole driver, it would not explain the tandem widening in both sectors. Further, the extent
of the reaction and correlated weakness across industries and issuers is a symptom of illiquid
markets. In fact, issuers in Technology and Media suffered significant losses on a virtual
absence on relevant new information.
TCH market update
With the Dow falling over 1,000 points in two trading days and significant
widening of credit spreads in fixed income, we want to share an update
regarding our market views and our approach to investing in this environment.
Fixed Income Insights
TCH perspective on
current market conditions
bmofunds.com
bmo-global-asset-management
1-844-266-3863
Taplin, Canida & Habacht (TCH)
is an institutional fixed income
boutique within The Bank of
Montreal and part of the BMO
Global Asset Management group.
TCH manages over $10 billion
of assets and is a subadvisor for
multiple open-end mutual funds.
We are dedicated to investing on
behalf of our clients and servicing
them to the highest standards.
For more information about TCH,
please visit tchinc.com.
Contact us
Source: Barclays
Percent
Jan 2011 July 2011 Jan 2012 July 2012 Jan 2013 July 2013 Jan 2014 July 2014 Jan 2015 July 2015
Option adjusted spread
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Metals and Mining
Energy
Credit
Asset Management September 2015
2. Concern over a worse-than-expected outcome for growth
deceleration has justifiably increased. For example, Chinese PMI,
the most watched higher frequency indicator of economic activity,
is once more flirting with sub-50 levels. But, the broader question
has always been the Chinese government’s willingness and ability
to stabilize its economy. We continue to find substantial evidence
of our view that a central economy with ample resources and basic
economics can make a soft landing achievable.
Classic economic actions like the recent currency devaluation,
People’s Bank of China (PBoC) easing, long-term refinancing
operations (LTRO)-like programs and more central authority-driven
ones like the transfer of some China Securities Finance Corp equities
holdings into a sovereign fund to help stabilized markets are potent
examples of such actions.
We expect these and future actions to achieve their objectives,
but will watch economic activity indicators very closely to test our
thesis. For example, we examine commodity demand indicators to
help frame our expectations for a return to rationality in spreads.
Below is an index of iron ore deliveries to China. Examining
deliveries versus the corporate spreads of one of the largest
iron ore producers demonstrates that spreads have widened
substantially by both absolute and relative measures even for some
of the largest, most effective global producers with competitive
cost structures.
From an investment standpoint, we measure and assess risk, price
risk and determine whether market prices are over- or under-
shooting relative to our evaluation. Just as we find that oil prices
during the Great Recession provide a reasonable reference for
market stress, we look at the relative valuation of Metals & Mining
issuers to determine the extent to which the fulcrum of China fears
has priced a slowdown.
An example is our analysis that compared option adjusted spreads
(OAS) of the Metals and Mining sector to overall corporate option
spreads to help frame our relative value assessment. There are only
two months since Barclays data became available (1994) when the
relationship was wider than at the end of July (1.55): December 2008
and January 2009.
These periods are reasonably viewed as significantly more stressed than
today both in terms of fundamental growth expectations and market
environment. And while the overall level of spreads was higher then,
the relationship between the two does provide a useful reference.
In addition, while brinkmanship between North American and Saudi
interests may continue to cause concern, some encouraging signs
have evolved. For example, the August report of the three main
energy organizations—International Energy Agency (IEA), U.S. Energy
Information Administration (EIA), Organization of the Petroleum
Exporting Countries (OPEC)—indicated that supply growth declined in
July and revised supply outlooks lower. Simultaneously, they revised
demand outlook higher, reflecting lower oil prices.
So, how rational are fears of a China hard landing and to what extent has the market reacted to the news?
Metals and Mining vs. Corporate option adjusted spread
Percent
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Barclays
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Source: Bloomberg
Jan
2014
Mar
2014
May
2014
Jul
2014
Sept
2014
Nov
2014
Jan
2015
Mar
2015
May
2015
Jul
2015
Aug
2015
Iron ore delivered to Qingdao, China
$/metric ton
30
60
90
120
150
Asset Management September 2015Fixed Income Insights
2
3. Conclusion
While credit exposure has underperformed across sectors and
securities with little differentiation in the current environment,
systematic decision making is the basis of successful investing.
In the short run, this environment is predictably difficult for
fundamental investors, but a dislocated market offers opportunities
as we expect that a return to rationality and stability will also return
to security valuation differentiated by fundamentals.
Avoiding reactive risk-averse behavior is as important to long-term
results as correctly assessing risks. Such inefficient risk-pricing
conditions are particularly well suited for combining top-down
and bottom-up analysis to identify attractive risk-adjusted
opportunities—the core of our investment approach.
Corporate debt issuance, according to The Securities Industry and
Financial Markets Association (SIFMA), has been almost 15% higher
year-to-date through July versus the same period last year. At the
current rate, 2015 is on pace for over $1.6 trillion of corporate debt
issuance. The issuance of the past three months (May, June, July),
typically the beginning of a slower summer period, has exceeded
any three-month period in 2014, which was the year with the
biggest corporate debt issuance to date.
With so many corporations sharing the same mindset of concern
regarding rising interest rates, many rushed to issue debt before
their cost of funding rose. With so much focus on interest rates,
ironically, the glut of corporate issuance in a lower liquidity
environment with weak demand has been the greater risk to fixed
income markets.
While much of the recent discussion surrounding fixed income
investment has focused on the expectation of rising interest rates,
recent market developments and the impact on U.S. equity markets
have reemphasized the difficulty in predicting the direction of
interest rate moves, particularly in the short run.
The first equity market correction since 2011 has reinforced, in our
view, the pitfalls of market timing. We have long been of the opinion
that a core fixed income allocation has the role of providing stability
to a diversified portfolio and aggressive shortening of duration can
diminish its ability to fulfill that critical role. Maintaining a neutral
duration and barbelled term structure has been beneficial to our
strategies as the market stress has pushed risk-free term structure
premia lower.
Why does issuance matter? Weren’t rates supposed to go up?
U.S. Corporate Bond issuance by calendar year
$ billion
2009 2010 2011 2012 2013 2014 2015 projected
Source: SIFMA
0
500
1000
1500
2000
Asset Management September 2015Fixed Income Insights
3
