Tuesday, April 21, 2020

BBB downgrade risk: Less than meets the eye?


Worries over declining credit quality may be overblown

 


by Trae Willoughby/Victory Capital

QUICK READ

  • Sharp growth in the BBB credits has raised fears about mass downgrades, losses in value and a swamping of the high-yield segment. We believe this narrative may be overly alarmist, given the sources of the BBB increase.
  • For instance, in recent years, the level of new BBB issuance from that of “fallen angels— companies downgraded from investment-grade moving in the opposite direction.
  • Agency ratings offer limited information on a company’s credit outlook. We use these ratings as just the starting point in our rigorous research process, which yields an independent view of potential risks and rewards.

Digging into the numbers

In recent months, much attention has been focused on the perceived risks posed by the rapid growth in BBB-rated corporate debt. This bottom rung of the U.S. investment grade (IG) ladder represents more than 50 percent of the IG universe. In dollar terms, at more than $2.3 trillion, BBB debt is now nearly triple its level in 2011.

Post-Crisis Growth for BBB Segment

Investment-grade bonds by rating ($ billions)


Some market watchers worry that an economic downturn could trigger widespread downgrades of BBB credits into high yield (below BBB— at S&P or Fitch/Baa3 at Moody’s), which could result in substantial losses in value for existing bonds and lead to corporate distress as their borrowing costs rise significantly. There’s also concern that a wave of downgrades could be large enough to swamp the high-yield segment with new supply, which could hurt prices for existing bonds.

But in an investment-grade debt market worth nearly $4 trillion, broad-brush generalities can gloss over important nuances. A deeper understanding of the BBB segment requires an expertise in fundamental credit ratios, which are the material drivers of credit ratings. These ratios include leverage, interest coverage and EBITDA[1]  growth.

In recent years, BBB leverage has largely remained stable, which is ratings-neutral, while improving interest coverage and EBITDA growth are positive.


Rising Stars Nearly Offset Fallen Angels in Recent Years

Value of upgrades versus value of downgrades ($ billions)


Closer scrutiny of trends during the current cycle reveals that about a third of the BBB increase came from downgrades of higher-rated companies. Such downgrades can be due to the assumption of additional debt (often as a result of an acquisition) or the sale of a portion of the business and the return of capital to shareholders.

About 15% of the BBB increase came from opposite direction— speculative-grade companies being upgraded to IG status. This cohort includes “rising stars”— relatively new issuers that have built a solid credit record. Since 2013, the cumulative value of issuance by rising stars ($296 billion) is roughly equal to that of “fallen angels” ($305 billion)— issuers that have dropped from IG status to high yield.

The remaining 50% or so of new BBB debt was issued by BBB companies— these include a significant number of new issuers taking advantage of low borrowing costs and strong investor demand.


BBB Trends Can Vary by Sector

Market sector can also matte when analyzing upgrades, downgrades and those BBB issuers holding steady. Fixed income analysts at USAA Investments, A Victory Capital Investment Franchise, have identified sectors that illustrate each of the three categories, and they offer some color on current risks and opportunities.


Technology

The growth of BBB-rated technology bonds is largely from companies whose fundamentals improved as a result of acquisitions or because they issued secured debt, according to analyst Domingo Villarruel. About 40 tech companies issued BBB-rated debt, with Broadcom and Dell accounting for 11% of the issuance. Both were upgraded to BBB in 2016 after transformative acquisitions. Broadcom fits the profile of an A-rated company based on scale, margins and free cash flow, but its elevated leverage and acquisition history have weighed on its ratings. Villarruel says Broadcom’s $33 billion debt load gives management a powerful incentive to remain IG—slipping back into the high-yield ranks would likely raise its borrowing costs and complicate the funding for any future acquisitions.


Food and beverage

Senior analyst Michael Duncan says leveraged transactions by companies in the food and beverage subsector have hurt credit ratings and, in some cases, have led to downgrades. Anheuser Busch-InBev and Altria, for example, have been downgraded to BBB by two of the three major rating agencies, while all three agencies rate British American Tobacco at BBB. Debt-funded acquisitions have also weakened the credit profile of a number of existing BBB names— among them, General Mills and Campbell Soup—but not to the point of pushing them down to high yield. Many of these companies could sell off non-core assets or cut their dividends to alleviate ratings pressure, but for others, flexibility is limited by a tougher competitive landscape and diminishing brand strength. This suggests their resiliency may be reduced in the event of an economic downturn.


Pharmaceuticals

Senior analyst Bobby Jones, who tracks the health care sector, says leverage, as measured by the ratio of net debt to EBITDA, has increased among pharmaceutical makers. But that trend is offset to a large degree by the rising value of these companies in terms of the ratio of enterprise value to EBITDA. All else equal, high enterprise valuations indicate a greater ability to support leverage and repay debt. Strong cash flows, desire to retain access to lower cost funding and the option to reduce share repurchases all suggest to Jones that a number of companies—Allergan is a good example—have the means and the motivation to maintain their IG credit ratings. Mylan is another company with ratings at the lowest rung of the IG ratings ladder, but this, too, looks to be an improving situation given the recently announced merger with Pfizer. Combining their off-patent medicine businesses, both branded and generic, would likely lead to a ratings upgrade for the new company, Jones believes. It’s important to keep in mind that the agency ratings only tell you so much about a company’s credit outlook.


Debt Ratio is Up for Pharma, But so is Sector Value

Net debt/EBITDA versus Enterprise value/EBITDA


We believe that these ratings should be just the starting point of rigorous fundamental research. For us, that means generating our own independent rating on each bond we hold, as well as continuously monitoring credit quality. This is especially important in lower credit rating tiers where nuances matter and the market might make incorrect assumptions. We maintain that our process provides us with a more detailed view of the risks and potential rewards, and it enables us to be responsive when that risk/reward balance changes.


The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Victory Capital nor TEXPERS, and are subject to revision over time.

About the Author: 

Sources:
[1] EBITDA: Earnings before interest, taxes, depreciation and amortization. EBITDA is a commonly used alternative to net income when measuring financial performance.

Investment Insights

REITs: The missing ingredient for a holistic real estate allocation




By Daniel Greenberger, Greg Kuhl, & Suny Park/Janus Henderson Investors

In recent years, institutional investors have turned to a range of private investments – equity, debt and real estate - in search of higher returns. However, while private equities and debt have outperformed their listed counterparts for the past 20 years, the same cannot be said in real estate. REITs, as represented by the FTSE NAREIT All Equity Index (the NAREIT Index) have outpaced the CREIF ODCE (Open-End Diversified Core Equity) Index by 2.4% per year (on a gross basis) for the 20 years ended 31 December 2019. Our research indicates greater cash flow growth from specialty property sectors, which are, by definition, absent from private funds, primarily explains the historical outperformance of REITs.

Key Takeaways

  • Since the turn of the century, REITs have delivered low double-digit annualized returns;
  • REITs offer unique access to ’non-core’ property types with superior cash flow growth prospects and daily liquidity;
  • Many private funds concentrate their investments in retail and office, yesteryear’s bellwether properties now subject to oversupply, increasing operating challenges and excessive amounts of required capital investments.

REITs Produce the Returns of Their Underlying Properties

“REITs behave too much like equities” is one of the oldest criticisms of REITs and implies that private funds behave differently; however, the difference in relationships of REITs and private funds to listed equities is entirely due to the differences in timing and frequency of valuations. An independent study by CEM Benchmarking Inc. (CBI) examining real estate returns of over 200 U.S. pension funds revealed REITs and private funds exhibit over 90% correlation, once private fund returns are restated to more accurately reflect the timing of changes in property valuations. Any perceptions that private funds provide for a lower risk approach, and are not subject to market gyrations, is entirely due to a long reporting lag. This was evident during the Global Financial Crisis. For the pension plans analyzed by CBI, REITs experienced a sharp sell-off of 38% in 2008. Private funds suffered the same 38% loss; however, it was reported over a two-year period, publishing a modest loss of 8% in 2008 before reporting a much larger 30% loss in 2009, as shown in Exhibit 1A. 

Exhibit 1A: CBI As-Reported Private Real Estate Fund Performance 




Once private fund returns are standardized, they exhibit a much higher correlation with REITs, as shown in Exhibit 1B.

Exhibit 1B: CBI Standardized Private Real Estate Fund Performance




Growth of Specialty Property Sectors – An Important Return Driver for REITs

The listed REIT sector was early to embrace specialty property sectors - self-storage, cell towers, data centers, single tenant net lease, and manufactured housing – which has been an important driver of the return differential between REITs and private funds. As shown in Exhibit 2A, as of 30 September 2019, non-core property sectors were noticeably absent from the NCREIF Property Index (NPI), whereas, they accounted for 58% of the Nareit Index. And as shown in Exhibit 2B, non-core sectors have grown from 26% in October 1999 to 58% in September 2019 of the Nareit index.

Exhibit 2A: Comparative Sector Allocation - Nareit Index vs. NPI 


Exhibit 2B: Nareit Index Sector Allocation - October 1999 vs. September 2019



Due to their differentiated operating platforms and the granularity of their individual property holdings, in our opinion, specialty property types are more commonly found in, and better suited to, the listed market. By their very nature, investments in specialty property types tend not to be compatible with the structure and cadence of private equity capital raising, investment, and distribution of capital.

We expect non-core specialty sectors to continue to outpace core sectors due to higher initial unlevered yields, demand-driven higher secular growth leading to landlord pricing power, and generally lower recurring capital expenditures supportive of higher free cash flow growth. As private real estate managers find it more difficult to expediently deploy capital in specialty property types, institutional investors not allocating to listed REITs risk missing the potential outperformance associated with investing in these more favorably positioned sub-sectors of the real estate market. 



Opportunities Amidst an Uncertain Economic Environment

We take a long-term view of the opportunities that exist in the Global REITs market, but can’t ignore the recent market downturn and the threat that the Coronavirus outbreak has to long term economic growth. We share some perspectives below:

  • REITs offer three key elements - Dividends, Diversification and Defensive Growth. We think these characteristics are currently priced at GFC levels and reflect an attractive basis. Investors do need to be active and selective, so they can benefit from long term structural and technological tailwinds. A focus on the sustainability of underlying income streams and balance sheet strength is needed to avoid REITs that will suffer more during an economic slowdown. When compared to their unlisted brethren, REITs also tend to employ lower leverage levels versus private opportunity and value-add funds.
  • REITs entered the COVID-19 crisis with their strongest, most liquid balance sheets in their history. Real estate fundamentals in some sectors will be disproportionately impacted by tenants’ inability to meet near term rental obligations. This should be most acute across retail and hotels properties. REITs in other areas including industrial and many specialty sectors will find themselves more insulated. Volatility creates opportunity: The daily liquidity of REITs, an important asset allocation and risk management tool not generally available to private real estate managers, allows for opportunistic repositioning of portfolios as stock prices and property market fundamentals change.


Conclusion

REITs have delivered low double-digit net-of-fee returns since the turn of the century and can access growth opportunities in specialty property sectors. Moreover, secular headwinds facing core sectors such as retail and office strongly suggest more private property write-downs are waiting in the wings. Despite a steadily growing market, REITs have been a forgotten asset class among institutional investors. If the past 20 years of listed real estate experience is any guide, it behooves institutional investors to reassess REITs as a strategic return-enhancing asset class deserving of their attention. Our advice is not to supplant but rather to supplement a private real estate allocation with a REIT allocation because, in our opinion, the latter will not only offer institutional investors more complete exposure to all real estate sectors but may improve risk-adjusted returns of their overall real estate allocations.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Janus Henderson Investors nor TEXPERS, and are subject to revision over time.

About the Authors:

Investment Insights

Portfolio diversification in the COVID-19 era


Image by Miroslava Chrienova from Pixabay.

By Mark Shore/Coquest Advisors

Over my 30 plus years in the capital markets, it appears there is never a bad time to discuss diversification. However, the current market environment suggests a more inviting moment to discuss the topic as noted in Figure 1 of the frequency of Google “stock market” term global searches as equity markets declined. Several of my past articles discussed various concepts of diversification, the current market interest affords another opportunity to review this topic.

Figure 1


Market corrections and/or economic contractions are often related to structural changes or changes in market confidence.  However, in the first several months of 2020, many economies were government-mandated to shut down and practice social distancing to fight the COVID-19 breakout except for “essential businesses”. COVID-19, an exogenous shock to the world economic system; an event-driven global economic slowdown.


As COVID-19 spread across the globe in 2020, the capital markets repriced in Q1. During this global crisis equity markets, commodities and REITs declined as noted in Figure 2. The VIX spot and VSTOXX spot volatility indices rallied and met or exceeded their financial crisis highs as implied volatility priced into the 80s. In a normal market environment, VIX and VSTOXX volatility indices tend to be range-bound between low teens to low 30s. Implied volatility priced in the 80s usually indicates a nervous market, last seen in 2008/ 2009.

The “lower for longer” interest rate mantra continues. What is probably the first time in American history (or at least post-WWII) on March 9, 2020, the entire U.S. yield curve temporarily declined below 1%. Except for the 30-year bond, the yield curve has primarily remained below 1% for the last several weeks.[1] During the Great Depression of the 1930s yields were higher, high-grade commercial paper yielded 0.75% until it moved higher in 1937[2].

2020 Returns

Figure 2


Fig. 2 shows the March 2020 returns for various asset indices. Except for managed futures, the indices declined. Fig. 3 notes the Q1 returns declined by double digits, except for managed futures experiencing positive returns.

Figure 3


When examining any index, the result is an average of the index’s constituents. Meaning some constituents are underperforming and some are outperforming the index, but it offers an indication of behavior.

Why Did Managed Futures Experience Positive Returns?

Managed futures, also known as Commodity Trading Advisors (CTAs), parsing their returns by sub-sectors, the Q1 returns ranged from an average of -0.18% for discretionary managers to an average of 6.95% for currency traders, demonstrating not all CTAs are the same.

You may be asking why did CTAs experience positive returns in Q1? The history of CTAs tends to offer similar results during negative equity quarters as suggested in “Downside Analysis of the S&P 500 Index”.

Between Jan 1980 and June 2019, SPX experienced 50 negative quarters with an average return of -6.3% and a maximum loss of -23.2%. During those same quarters, CTAs averaged 3.3% returns with a maximum gain of 36.9% and a max loss of -8.9%.
Quick summary of managed futures:

  1. CTAs may take long or short positions in multiple futures markets including, equity indices, fixed income, forex, metals, energy, grains, softs, volatility indices and options on futures, allowing for various potential market opportunities.
  2. Their risk management may be more quantitative relative to say a mutual fund manager. Their risk management may offer positive skewness to a CTA’s return distribution. This could be a value-add to an investor’s portfolio as discussed in my 2019 article, “The Good and Bad of Volatility”.
  3. CTAs trade in the futures and forex markets versus hedge funds frequently trading in the equity and fixed income markets.
  4. Their duration of holding periods may range from intra-day to holding positions for several months.
  5. Their strategies may vary to include from trend-following to spread trading (aka relative value).
  6. Some CTAs trade one market or sector. Some may trade only commodity futures or only financial futures. Some may trade across a spectrum of financial and commodity futures.


This is a short-list of items[3], but it begins to explain why managed futures may offer non-correlation to equities and many other asset classes including several hedge fund strategies and why they may experience positive performance in stressful economic cycles.

At the 2019 Illinois Economics Association, I presented correlation risk research relative to various hedge fund strategies. Several strategies offer an extension of a portfolio’s equity exposure and others are more of a diversifier such as CTAs. A summary of the presentation is found here.

The correlation rankings in Fig. 4 suggest hedge fund strategies contain various correlations to equities. The allocation of a given strategy should depend on the investor’s goal.

Figure 4


I once heard a pension fund CIO mention, to protect the portfolio, you can’t prepare for the last battle, you must prepare for the next battle.  The current market environment demonstrates this concept as a different catalyst triggered this crisis is different from the Great Recession and most other economic contractions in at least modern times. Yet, the strategy behaviors are finding similarity to past events.

Summary
As the catalyst is different from most market corrections, the market behavior offers similar results as suggested by historical data. Equities tend to be highly correlated in selling environments. Long-only commodity indices and REITs demonstrate their positive correlation to the economic cycle. We never know when the next downturn will occur, therefore examining the utility of non-correlated returns may assist to mitigate tail risk losses.

If you have questions or would like to receive more information on this topic, please feel free to contact the author at mshore@coquest.com. The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Coquest Advisors nor TEXPERS, and are subject to revision over time.

About the Author: 



[3] Shore, M. (2018). Managed Futures Lecture Notes. DePaul University, Chicago.

Investment Insights

Stress testing companies for an impending recession




By James T. Tierney Jr. and Mark Phelps/AllianceBernstein

The new coronavirus crisis is different than any other seen in our lifetimes. But equity investors who develop a clear set of characteristics that will define resilient companies in the evolving environment can position portfolios to get through the pandemic and benefit from an eventual recovery.

Investors are reeling from the speed of the market collapse. The onset of a bear market in recent weeks happened faster than ever before, and GDP will likely drop precipitously over the next two quarters. However, every downturn throughout history has also provided opportunity. It’s extremely difficult for investors to envision a recovery at a time when the virus is spreading, the death toll is rising and entire populations are being locked down around the world. Yet given the unprecedented level of global monetary and fiscal stimulus, we believe this opportunity could come sooner than most expect.

Identifying Resilience and Staying Power


As investors survey the market carnage, the first order of business is to determine which companies have the staying power to ride out this downturn. This involves taking a close look at a company’s underlying business demand, financial position and ability to cut costs. No one knows the duration of this economic downdraft, but if you can’t be highly confident that a company will still be around when this is over, you’re probably taking undue risk.

How can investors dig deeper into a company’s true resilience? Start by building models of monthly cash burn under various scenarios. For example, how would the company perform in a sharp V-shaped recovery versus a U-shaped recovery? In a V-shaped recovery, a massive short-term demand contraction is followed by a sharp rebound. In a U-shaped recovery, short-term demand also drops precipitously, but the pickup is much slower due to lower personal income, damaged consumer balance sheets and a loss of consumer confidence.

These patterns might also unfold in multiple phases of demand drops and recovery. This is already playing out in Hong Kong, Taiwan and Singapore, which had some success in containing the virus but are now experiencing a second wave of infections. Modeling performance for different scenarios is a challenging exercise but can provide vital intelligence for forecasting the prospects of companies in highly uncertain conditions.

It’s also important to get a better understanding of debt maturity schedules and debt covenants. And ask whether you have enough trust in the management team, since companies will require skillful captains to steer through this crisis. Bankruptcies are clearly going to increase over the next year. But we believe that investors shouldn’t bank on government bailouts, which are notoriously difficult to predict.

Survival of the Fittest


Downturns can have a Darwinian effect on companies and industries. When recession strikes, strong companies tend to get stronger while the weak get weaker or disappear. We believe this dynamic will play out in the coronavirus crisis.

The retail sector is a good example. As demand dries up, several weaker retail chains probably won’t make it far into 2021, in our view. While that is unfortunate for their employees and shareholders, their revenues will go to the survivors. So, the earnings crunch in 2020 could lead to stronger and more profitable business in the years ahead for companies that make it through. Even amid today’s uncertainty, investors should strive to identify the fittest companies that are likely to survive and should be able to deliver robust earnings and returns when the markets eventually turn.

Changing Behavior Will Change Demand Patterns


Beyond the immediate downturn, questions about longer-term shifts in demand curves must be asked today. The lockdown in the US and much of Europe has only just begun, and people everywhere are experiencing startling changes to work and everyday life. Will this experience make employees and companies more comfortable with remote working arrangements and, in turn, permanently reduce demand for big city office space? Will business travel be permanently reduced as we become more acclimated to video meetings? Is demand for “experiences” like theme parks and cruises going to be permanently impaired? What about grocery shopping; for many, the biggest hurdle to online grocery shopping is getting comfortable placing the first couple of orders. Now that millions of people are being forced to shop for food online for at least the next few weeks, the dynamics of demand for supermarket shopping could change forever.

Think About the New Normal Now


How will the business recovery pan out when some sense of normalcy resumes? Investors should consider the potential different scenarios across industries. For example, if people haven’t driven cars to work for a month, demand for new tires could be deferred.

Conversely, after being cooped up at home for weeks on end, people may discover things they want to fix or upgrade, which could trigger a surge of business for home-improvement retailers when the crisis is over.

In the throes of a historic market event, it’s hard to see through the fog. But investors who ask the right questions now will be able to pinpoint companies that can survive the stresses of the impending recession and identify behavioral changes that will reshape industries, companies and stocks when the pandemic subsides and a new normal is restored.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. 

About the Authors:


Reviving Our Pension Backgrounders for Texas Journalists

On July 2, 2010, TEXPERS began blogging for the purpose of explaining how pension funds work and examining issues which needed reality checks. We were then coming out of the 2008-09 market calamity that was sparked largely by collateralized debt obligations, meaning high-risk mortgages. 

We shared our blog posts over several years with Texas and national journalists, in the hope of shedding light on cloudy, complicated public employee pensions. The many opponents to defined benefit plans for public employees were taking their shots, through the media, at these plans. As we worked our way through debunking critics, many journalists let us know that they kept our writings handy for times when they had questions. In sum, we succeeded in becoming reporters’ go-to source for issues involving public employee pensions in Texas.

For us it is 2010 all over again. We now see the need to re-ignite our efforts, for you. The critics of defined benefit plans have already started their ‘sky-is-falling’ campaign against public employee pensions. We hope you will view their claims with some skepticism, and give us the chance to refute them. 

Here’s some reasons you should give us the benefit of the doubt. In 2008, the Dow Jones Industrial Average closed at 8,776 and many did not think it would ever again achieve its previous all-time high of 14,164. Earlier this year, the DJIA reached an all-time high of 29,551.  

The key here is that pension funds for public employees invest for the long-term. They may have a 30-40 year time horizon for investments. They don’t panic and sell at the bottom. They know that markets can get side-swiped by pandemics or other shocks. But markets have a solid history of coming back. Strong. Knowing this, pension funds and their investment managers are the strong hands of the market, providing stability and new cash infusions at the best possible time.

We have been working to keep Texas reporters apprised of how pension funds can recover, over time, with the tried-and-true method of dollar-cost averaging.  Our yearly reports on the improvements in amortization periods of Texas pensions have chronicled their success at putting the 08-09 crisis behind them.

Over the next 10 years we are sure we will be chronicling how they put the 2020 pandemic market behind them as well.

With that in mind, we hope you will check in with us when you see some alarmist press release come across your desk. The opponents to public employee defined benefit plans often get things wrong and fundamentally don’t understand how these systems function. They don’t know that most public employees don’t receive Social Security for decades of work. They don’t know that defined benefit plans are deferred compensation that is earned by public employees. They don’t understand the implicit value of keeping public employees on the job delivering civil service over decades.

We do understand those dynamics and we will working to share them with you, again. 

Thursday, April 9, 2020

PRB to work with plans facing delays in mandated reporting due to pandemic




State and local public pension plans experiencing operational disruptions due to COVID-19, the new coronavirus causing an outbreak of respiratory illness and workplace shutdowns worldwide, should reach out to the Texas Pension Review Board if state-mandated reporting deadlines cannot be met. 

The Pension Review Board recently posted an update to its website stating the state agency understands interruptions caused by the current pandemic may affect the ability of plan administrators to submit reports. However, the message does not provide specifics on how agency staff will be able to work with pension plans. 

“We understand that plans may be experiencing disruptions due to COVID-19, which may affect the ability to submit timely reports,” the PRB states on its website. “The agency will work with any plans affected to address delays in reporting. Staff is available to assist in any way we can.”

TEXPERS reached out to the PRB to obtain additional information and will update this article as more details become available.

State and local public pension plans are facing a May 1 deadline to begin providing an analysis of each retirement system’s investment processes. The new report is the result of Senate Bill 322, signed into law by Gov. Greg Abbott on June 10. 

The bill requires pension plans to begin reporting how much each fund spends seeking returns through bonds, stocks, hedge funds, real estate, private equity, and cash. Some TEXPERS members were hoping to have an extension on the new report’s deadline, but because it is established by law, Pension Review Board staff are unable to change the reporting deadline. 

Plan administrators may call the Pension Review Board’s Austin office at 512-463-1736 or visit its website at www.prb.texas.gov to obtain additional information.

About the Author: