AAM Investment Rethinking Risk Roundtable A CIO Perspective Reed - - PowerPoint PPT Presentation

Rethinking Risk A CIO Perspective AAM Investment Roundtable

Reed Nuttall, CFA Chief Investment Officer AAM

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Fed Tightening Usually Inverts Treasury Curve

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% Yield

Treasury Curve & Fed Funds Rate

Fed Funds 2 Year 10 Year

Source: National Bureau of Economic Research, Bloomberg

3 Source: National Bureau of Economic Research, Bloomberg

• 2.0%
• 1.0%

0.0% 1.0% 2.0% 3.0% 4.0%

Dec-1980 Dec-1981 Dec-1982 Dec-1983 Dec-1984 Dec-1985 Dec-1986 Dec-1987 Dec-1988 Dec-1989 Dec-1990 Dec-1991 Dec-1992 Dec-1993 Dec-1994 Dec-1995 Dec-1996 Dec-1997 Dec-1998 Dec-1999 Dec-2000 Dec-2001 Dec-2002 Dec-2003 Dec-2004 Dec-2005 Dec-2006 Dec-2007 Dec-2008 Dec-2009 Dec-2010 Dec-2011 Dec-2012 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Dec-2017

Yield Difference

Yield Differential: 10 Yr and 2 Yr Treasury

Economic Contraction Fed Tightening Cycles 2Yr - 10Yr Yield Difference Average Yield Difference = 1.06%

Inverted Curve Precedes Contractions

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Asset Allocation to Generate 7.5% Expected Return

Source: Blackrock

Reaching for Return Amid Low Rates

5 Source: Blackrock

Reach for Return Leads to Increased Volatility

Asset Allocation to Generate 7.5% Expected Return

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Key Market Themes

• Underweight Agency MBS
• Reduce basis in BBBs
• Changes in tax rate cause reallocation to taxable sectors

5.3% 10.2% 12.7% 10.0% 34.7% 3.8% 2.6% 10.3% 9.8%

Tax Reform Effects on Municipal Market Technicals Municipal Credit

Greg Bell, CFA,CPA AAM Principal and Director of Municipal Bonds

1

• Tax rates reduced
• Individual rates reduced from 39.6% to

37%

• Corporate rates reduced from 35% to

21%

• Corporate AMT eliminated
• Advance refundings eliminated
• State and local taxes deduction capped at

$10,000

Tax Reform

2

BEFORE AFTER CHANGE

10yr Muni Yields 2.46% 2.46% Retail Tax-Equivalent Yield 4.35% 4.16% (.19%) P&C Tax-Equivalent Yield 3.59% 2.95% (.64%) Bank Tax-Equivalent Yield 3.78% 3.11% (.67%)

Source: AAM, Thomson Reuters Municipal Market Data

Demand Effects: Changes in Tax Equivalent Yields

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Source: AAM, Thomson Reuters Municipal Market Data, A- rated spreads generated from Northeastern University pricing

• n 6-20-18

5yr 'AAA' Muni to 'A' Corp 5yr 'A' Muni to 'A' Corp 10yr 'AAA' Muni to 'A' Corp 10yr 'A' Muni to 'A' Corp

Tax-Exempt Yields 1.99% 2.14% 2.46% 2.76% Retail Tax-Equivalent Yield Spread (0.05%) 0.20% 0.41% .91% P&C Tax-Equivalent Yield Spread (1.03%) (0.85%) (0.81%) (0.45%) Bank Tax-Equivalent Yield Spread (0.89%) (0.78%) (0.64%) (0.26%)

Demand Effects: Tax-Equivalent Yield Spreads to Taxables

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(in Billions)

Q4 2017 Q1 2018 Change

Retail (Household, Mutual and Money Market Funds) $994.3 $992.3 ($2) P&C $326.9 $326.9

• Bank

$570.2 $554.3 ($15.8)

Source: Federal Reserve Flow of Funds Data

Demand Effects: Changes in Market Concentration

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• 60.00%
• 40.00%
• 20.00%

0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 140.00%

• 00

200.00 400.00 600.00 800.00 1,000.00 1,200.00 1,400.00

6/14/2016 12/14/2016 6/14/2017 12/14/2017 6/14/2018

Percentage Par Amount ($mn) Date

Daily Bid List Activity (30 Day AVG) 30 Day AVG Relative to 3 yr AVG

Source: Bloomberg

Demand Effects: Selling Remains Elevated

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Source: Bond Buyer

Supply Effects: Refinancings Have Slowed

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(80) (60) (40) (20) 20 40 60 Monthly Issuance (billions)

Trailing 3 Month Total Net Supply

Source: J.P. Morgan

Supply Effects: Net Supply Levels Very Supportive

8

Source: Bloomberg, Thomson Reuters Municipal Market Data

Relative Valuations Should Improve

70% 75% 80% 85% 90% 95% 100% 105% 110% 115% 120% 6/19/13 8/19/13 10/19/13 12/19/13 2/19/14 4/19/14 6/19/14 8/19/14 10/19/14 12/19/14 2/19/15 4/19/15 6/19/15 8/19/15 10/19/15 12/19/15 2/19/16 4/19/16 6/19/16 8/19/16 10/19/16 12/19/16 2/19/17 4/19/17 6/19/17 8/19/17 10/19/17 12/19/17 2/19/18 4/19/18

Ratio

10yr Muni/TSY Yield Ratio

10yr Muni/Tsy Ratio 5yr Average Ratio

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• Supply accelerates
• Fed raises rates aggressively
• Headline risk or credit deterioration

Potential Headwinds

Need a title Structured Products

Scott Edwards, CFA AAM Director of Structured Products

2

Total Debt Balance and its Composition

3

Percent of Balance 90+ Days Delinquent by Loan Type

4 Source: Intex, Bureau of Labor Statistics, Bank Of America Global Research

Prime Auto Loan ABS- 30+ days Delinquencies, Net Loss Subprime Auto Loan ABS- 30+ days Delinquencies, Net Loss

Credit Performance- Auto Loan ABS

5

Del Amo Fashion Center, Torrance, CA

Del Amo Fashion Center is a 2.5 million square feet super-regional mall located in Torrance, California, boasting over 200 retailers, a multiplex, and multiple restaurants. The Mall is owned and operated by Simon Property Group.

• Debt Service Coverage Ratio (DSCR) 2.44x
• Occupancy-85%
• Loan-to-Value-51%
• Major Distressed Anchors include JC Penney (December 2018

lease expiration), Macy’s, and Sears

• Macy’s Home store replaced by Dick’s Sporting Goods and EMC

Seafood

• AMC multiplex was upgraded to add IMAX screens
• Nordstrom store was re-located and new Dave and Busters,

Marshalls to open in summer of 2018

• In talks with major grocery and hospitality operators for vacant

spaces

• Major redevelopment of $423 million being undertaken, with

enhanced dining pads and seating, several anchor spaces improved, and addition of multi-level parking

Source: S&P Presales, Morningstar, Servicer Reports

Retail Turnaround

6

Seritage Growth Properties is a publicly traded REIT, spun out of Sears Holdings in 2015. They are primarily engaged in re-leasing and redevelopment of 253 Class A multi-tenanted shopping centers, and 28 additional properties through a joint venture with

• ther REITs.
• Since 2015, Seritage has diversified their rental income away

from Sears. Sears’ contribution went down from 80% to 45.7%

• In doing so, Seritage also was able to realize 4.1x the rent

multiple of income produced by leasing to Sears

Source: Seritage Growth Properties Website

“Sears. Where Else?”

Disruptive & Opportunistic Autonomous Vehicles (AVs)

Afrim Ponik, CFA AAM Senior Credit Analyst

2

• 1.2B cars globally to grow to 2 billion by 2040s at current

trends

• 90MM of annual sales to grow to more than 120MM if EMs grow

at similar rate

• 11 trillion miles driven could more than double in 20 years
• 20 trillion in auto assets being utilized no more than an hour a

day

• Disruption is driven by efficiencies, infrastructure, costs, and

returns on capital

A Natural Shift Driven by Necessity

What Is A True Level 5 – AV?

3

AV Penetration Is Immaterial Over The Next Decade

4

• Electric, self driving vehicles a must, to meet globally ambitious emission needs

and improve the urban environment

• Autonomous capability will reduce the cost of driving sharply - by improving

efficiency, improving safety, and providing billions of hours of leisure time

• Shared networks will reorganize ownership and logistics of the automotive assets

to improve efficiency and reduce car population

• These developments will disrupt not just the transportation industry, but the way

adjacent industries work

Multiple Industries Impacted

5

Positives:

• Significant load growth from charging stations
• Significant infrastructure build, which means revenue growth
• Push to renewables, also would require new investments, rate growth

Negatives:

• Further development in battery technology/Utility scale battery storage solution there will be

little to no demand peak generation, negative for merchant generation

• Car’s battery, additional battery storage and solar panels, could increase distributed

generation capacity in sunny states

Utilities - Overall a positive for the sector

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• Expands the addressable market for technology companies

Source: MIT Technology Review 3/12/18

Technology - A Positive For The Sector

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Telecom - A Positive For The Sector

8

Positives:

• Battery production will increase materials demand, requiring more Lithium, Nickel, and

Cobalt, and Copper

• Infrastructure build out, such as charging stations, communication equipment on roads,

additional utility infrastructure, will require more materials

Negatives:

• Reduced car production could impact demand for steel and aluminum
• Perceived increase demand can produce oversupply at times

Materials - Overall A Positive For The Sector

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Positives:

• Significant new revenue streams and potential to penetrate new segments
• At full adaption, margins should be superior
• We could see more vertical integration, example: Tech/Auto in future years

Negatives:

• High R&D and Capex will keep the AVs and EVs unprofitable for a while
• Not all OEMs will be winners in the race to penetrate a new market
• Arguably higher utilization will reduce overall need for vehicles, rental cars

Automotive – There Will Be Winners And Losers

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Positives:

• Time to transition from insuring traditional vehicles
• Accident frequency declines, but severity increases
• The potential new insurance market penetration of the following three new sub-categories:
• Cyber Risk
• Software and Hardware
• Infrastructure

Negatives:

• Insurance is out of the value chain of building AV cars
• Reduction of traditional auto premiums
• Fat-tail risk hard to quantify

Insurance - Overall A Neutral For The Sector

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Positives:

• Consumers preference (SUV market share has increased to 68%)
• Potential changes to CAFE standards
• Demographic changes worldwide should lead to greater consumption in EM

Negatives:

• Current CAFE standards should promote EV adoption
• Battery costs continue to decline
• EV market share continues to grow (1.3% presently)

Energy - Uncertain for the sector

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Positives:

• While loosing parking demand, airports will gain real estate and revenue streams for access

to the airport and reduce congestion

• New infrastructure investment, could mean new revenue sources for toll roads and charging

station providers.

Negatives:

• Less need for parking, will negatively impact garages and street parking concessions
• Less cars on the roads and better technology integration will reduce toll road demand
• Less cars being shipped will reduce demand for ports and rails

Infrastructure - Overall A Mixed Bag

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Is The Corporate Market Healthy? Corporate Credit Investing

Elizabeth Henderson AAM Director of Corporate Credit

2

Bank lending standards remain loose

• Indicators indicate stability:
• Credit Managers Index remains above 50

(expansion) and trended positively in 2017

• GS Financial Conditions Index at 5 year

average Capital markets are wide open

• IPO, leveraged loans (second liens), high yield,

emerging markets, private equity Yield curve is flattening

• Fed in tightening mode

Credit cycle indicators continue to remain supportive but the UST curve is indicating potential trouble ahead

Source: AAM, Bloomberg Barclays, Fed as of 4/30/2018 Source: Factset as of 6/ 19/ 2018

• 100

200 300 400 500 600 700

• 40
• 20

20 40 60 80 100

10/1/2000 7/1/2001 4/1/2002 1/1/2003 10/1/2003 7/1/2004 4/1/2005 1/1/2006 10/1/2006 7/1/2007 4/1/2008 1/1/2009 10/1/2009 7/1/2010 4/1/2011 1/1/2012 10/1/2012 7/1/2013 4/1/2014 1/1/2015 10/1/2015 7/1/2016 4/1/2017 1/1/2018

Basis Points %

Net % of Domestic Respondents Tightening Standards - C&I Loans for Large/Medium Businesses

% Tightening OAS

3

1.00 1.50 2.00 2.50 3.00 3.50 3/1/1998 9/1/1998 3/1/1999 9/1/1999 3/1/2000 9/1/2000 3/1/2001 9/1/2001 3/1/2002 9/1/2002 3/1/2003 9/1/2003 3/1/2004 9/1/2004 3/1/2005 9/1/2005 3/1/2006 9/1/2006 3/1/2007 9/1/2007 3/1/2008 9/1/2008 3/1/2009 9/1/2009 3/1/2010 9/1/2010 3/1/2011 9/1/2011 3/1/2012 9/1/2012 3/1/2013 9/1/2013 3/1/2014 9/1/2014 3/1/2015 9/1/2015 3/1/2016 9/1/2016 3/1/2017 9/1/2017 3/1/2018 times (x)

Debt to EBITDA leverage (x-commodities)

Average Median Source: AAM, Factset as of 3/31/2018

Debt Leverage at Corporations Remains Elevated

4

Source: Bloomberg, AAM (Corporate Yields calculated using Bloomberg Barclays Corporate Index OAS plus 10 year Treasury yield multiplied by (1-corporate tax rate); Earnings Yield is for S&P 500); as of 6/11/18

• 1.0

2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 12/ 31/ 2008 12/ 31/ 2009 12/ 31/ 2010 12/ 31/ 2011 12/ 31/ 2012 12/ 31/ 2013 12/ 31/ 2014 12/ 31/ 2015 12/ 31/ 2016 12/ 31/ 2017

%

Earnings Yield - Corporate Yield

Diffe re nc e (E a rning s - Co rpo ra te )

Co rpo ra te yie ld E a rning s yie ld

Higher yields, a more optimistic outlook for growth and lower tax rates should make it less compelling for companies to increase debt especially to repurchase equity

Source: AAM, Factset as of 3/31/2018

Credit Fundamentals Expected to Improve

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

3/1/2008 8/1/2008 1/1/2009 6/1/2009 11/1/2009 4/1/2010 9/1/2010 2/1/2011 7/1/2011 12/1/2011 5/1/2012 10/1/2012 3/1/2013 8/1/2013 1/1/2014 6/1/2014 11/1/2014 4/1/2015 9/1/2015 2/1/2016 7/1/2016 12/1/2016 5/1/2017 10/1/2017 3/1/2018

Shareholder payments as % Operating Cash Flow

Share buybacks (net) M&A Dividends

Source: AAM, Factset as of 3/31/2018

Shareholder payments ($B) – Expected to Increase Will companies use the increased cash to reward shareholders or reduce debt?

Source: UBS “US Equity Strategy: $2.5tr+ corporate "flow": where is it going?” 6/4/2018

Shareholders Benefited from Tax Reform in 1Q’18

6

Corporate market OAS is wider YTD with heightened volatility but valuation remains historically lackluster

Source: AAM, Bloomberg Barclays as of 6/14/2018

100 200 300 400 500 600 700 8/4/2005 2/4/2006 8/4/2006 2/4/2007 8/4/2007 2/4/2008 8/4/2008 2/4/2009 8/4/2009 2/4/2010 8/4/2010 2/4/2011 8/4/2011 2/4/2012 8/4/2012 2/4/2013 8/4/2013 2/4/2014 8/4/2014 2/4/2015 8/4/2015 2/4/2016 8/4/2016 2/4/2017 8/4/2017 2/4/2018 Basis Points

U.S. Corporate Investment Grade OAS

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1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 12/24/2003 12/24/2004 12/24/2005 12/24/2006 12/24/2007 12/24/2008 12/24/2009 12/24/2010 12/24/2011 12/24/2012 12/24/2013 12/24/2014 12/24/2015 12/24/2016 12/24/2017 $MM

Investment Grade Corporate Debt

AAA AA A BBB

• 50

100 150 200 250 300

7/16/2007 2/16/2008 9/16/2008 4/16/2009 11/16/2009 6/16/2010 1/16/2011 8/16/2011 3/16/2012 10/16/2012 5/16/2013 12/16/2013 7/16/2014 2/16/2015 9/16/2015 4/16/2016 11/16/2016 6/16/2017 1/16/2018

bps

BBB-A Industrial Rating Basis

Basis +1 Std dev

• 1 Std dev

Source: AAM, Bloomberg Barclays as of 6/14/2018

Reduce Risk in Corporate Credit