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Bigger Economic Green Shoots This Spring?

Bigger Economic Green Shoots This Spring?. Presented by: Dan Byrnes Senior Portfolio Manager AAM – Insurance Investment Management.

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Bigger Economic Green Shoots This Spring?

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  1. Bigger Economic Green Shoots This Spring? Presented by: Dan Byrnes Senior Portfolio Manager AAM – Insurance Investment Management Reproduction or use of these materials for any other purpose or by or for any individuals is strictly prohibited. The information contained in this presentation has been obtained from sources that AAM believes to be reliable, but AAM does not represent or warrant that it is accurate or complete. The views in this presentation are those of AAM and are subject to change, and AAM has no obligation to update its opinions or the information in this presentation. Neither AAM, nor any of their respective officers, directors, members, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this presentation or its contents. The securities discussed in this presentation may not be suitable for all investors. The value of and income from any investment may fluctuate from day to day as a result of changes in relevant economic markets (including changes in market liquidity). The information in this presentation is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results.

  2. It’s Baseball Season: Trivia Question • How many hot dogs are expected to be eaten in Major League ball parks this year: • ~ 3 million • ~ 14 million • ~ 20 million • ~ 28 million

  3. It’s Baseball Season: Trivia Question • How many hot dogs are expected to be eaten in Major League ball parks this year: • ~ 3 million • ~ 14 million • ~ 20 million • ~ 28 million

  4. Winter Wonderland • Fond Memories (?!) From This Winter in Chicago • 93% of Great Lakes Frozen – 2nd highest • 3rd coldest average temperature • Most days with low temps at or below 0o • 3rd snowiest winter

  5. Recent Consumer Data Underwhelming • What is driving these negative figures? • Weather? • Weaker Consumer? Source: U.S. Census Bureau, National Association of Realtors, Bloomberg, AAM

  6. Unemployment Rate Falling Fast Job Adds and Unemployment Rate Unemployment Rate • Unemployment rate falling dramatically • The Fed is concerned about the labor market Source: Bureau of Labor Statistics as of 2/28/2014

  7. Stubborn Low Employment/ Population Ratio Suggest Structural Changes Rate (%) Ratio (%) Source: Bureau of Labor Statistics; FTN Financial

  8. Long Term Unemployment Still An Issue • 27 Weeks and Over • Less Than 5 Weeks Source: Bureau of Labor Statistics; AAM

  9. Housing Still Strong Despite Higher Interest Rates Home Prices Home Affordability • At 100, median-income family just qualifies for mortgage on median-priced home. Source: Standard & Poor’s, Case-Schiller as of 12/31/13 Source: National Association of Realtors as of 12/31/13 • Housing has been a bright spot in the economy • Recent pace of gains likely unsustainable

  10. Still Spending Capital Goods Orders Change In Consumer Spending Source: National Association of Realtors as of 12/31/13 Source: US Census Bureau as of 1/31/14 • Spending has been good, but not robust

  11. The World Stage • There has been a lot of concern around China’s “slow” growth • Geopolitical concerns remain Russia Crimea GDP (%) Ukraine NATO Source: Bloomberg as of December 2013

  12. What’s All This Mean for Growth? Real U.S. GDP Growth During Expansions Forecast • 1Q GDP is expected to be weak – around 1.8% • Growth should pick up in the second half of the year • Average growth of 3% expected over the next two years Source: Bureau of Economic Analysis, BloombergForecast as of 2/28/2014

  13. What About Inflation? Source: Bloomberg; FTN Financial

  14. The Fed Under Yellen • Dovish reputation • Expected to maintain the course set by Bernanke if conditions meet expectations • More concerned about full employment than predecessors

  15. Fed Stimulus Exit • Forecast • If the economy grows as expected the Fed should have exited QE III by year end

  16. Work to do After QE • Fed Balance Sheet • Balance sheet will still be large and need to be wound down • Fed Funds rate increase expected mid-2015

  17. Limited Correlation Between Fed Policy and Long Term Interest Rates Source: Barclays, Federal Reserve,Data as of 3/28/14

  18. What About Interest Rates? • What could cause meaningful divergence • Higher • Faster growth • Concerns about Fed commitment to low inflation • Other? • Lower • Geopolitical issues • Dramatic slow-down in China • Weaker consumer Source: Bloomberg as of February 2014

  19. What Do I Do With All Of This?

  20. It’s Baseball Season: Trivia Question • What MLB stadium has the most expensive small beer? • Yankee Stadium • Marlins Park - $8 • Wrigley Field • Dodger Stadium

  21. It’s Baseball Season: Trivia Question • What MLB stadium has the most expensive small beer? • Yankee Stadium • Marlins Park - $8 • Wrigley Field • Dodger Stadium

  22. Status Quo: Investment Grade Fixed Income

  23. Corporate Bonds Remain Attractive Source: AAM, Barclays

  24. Technicals Expected To Remain Supportive Net Issuance Source: JP Morgan

  25. Investable And Attractive Risk-adjusted Assets The Corporate Market Has Grown And Is Lower Quality Note: AAM is not soliciting or recommending any action based on above material. Any views presented above represent the opinion of AAM at a given time and are subject to change Source: Barclays, Moody’s

  26. What Other Levers Can Be Pulled?

  27. No Free Lunch • Add interest rate risk via more duration • Add liquidity risk – commercial loans • Add credit risk – high yield and/or convertibles Source: AAM

  28. Duration Decisions • Common question: If interest rates are rising, should I shorten my portfolio duration? • Short Answer: No • Scenario testing shows the role income plays in returns No Change in Interest Rates Results greater than one year are cumulative Interest rate changes are assumed to happen evenly over indicated time period Source: Actual portfolios modeled in CMS BondEdge as of 8/31/2013

  29. What If Rates Rise Substantially? 200 Basis Point Rise In Interest Rates • Income is the key driver in fixed income performance • Stick to your knitting on duration • Scenario testing shows the role income plays in returns Results greater than one year are cumulative Interest rate changes are assumed to happen evenly over indicated time period Source: Actual portfolios modeled in CMS BondEdge as of 8/31/2013

  30. High Yield

  31. U.S. High Yield Corporate Bond Spreads • High yield spreads are slightly lower than their long-term average, while the risk-free interest rates are at historically low levels • Current spreads imply a default rate of almost 6% for the U.S. high yield market • Spread of the Credit Suisse U.S. High Yield II Index • Source: Credit Suisse

  32. Refinancing Risk Remains Low • Record new issue proceeds used primarily for the purpose of repaying or refinancing existing debt. • High Yield company fundamentals remain strong. • We anticipate defaults will be less than 2% for the overall market. High Yield Bond Maturities Source: BofA Merrill Lynch, Data as of December 31, 2013 (Updated quarterly)

  33. Not All High Yield Is Created Equal • A focus on Ba/B ratings substantially reduces the risk of impairments Yield (Percent) Default Rate (Percent) Source: Annual Default Study: Corporate Default and Recovery Rates, 1920-2013 Yield to Worst shown for B of A Merrill Lynch BBB, BB, B, and CCC & Below Indices as of 2/28/2014. Loss adjusted assumes 40% average recovery for senior unsecured bonds.

  34. In A Rising Rate Environment, High Yield Has Performed Well Sources: JP Morgan and BofA ML. BofA ML U.S. 10 Year Treasury Index (GA10), BofA ML U.S. High Yield Cash Pay (J0A0) Index. Prior to the inception of J0A0 on 10/31/1984, BofA ML U.S. High Yield Master II (H0A0) was used.

  35. Convertibles

  36. Convertible Securities-Equity-like Returns With Less Risk • Capture 70-80% of stock market advances • Participate in only 40-50% of stock market declines • Carry higher current yields as compared to common stock • Constant focus on maintaining consistent risk/return profile *

  37. Historical Issuance/Redemptions * Source: Barclays Research as of December 31, 2013. *Estimates for 2014

  38. Convertible Performance Drivers for 2014

  39. ZazoveConvertibles Performance During Rising Rates Rising rate periods included are: 10/31/93-11/30/94, 1/31/96-5/31/96, 9/30/98-1/31/00, 10/31/01-3/31/02, 5/31/03-7/31/03, 6/30/05-6/30/06,12/31/08-12/31/09, 8/31/10-3/31/11, 4/30/13-8/31/13. Note: Portfolio returns are reflected before management fees. Benchmark returns include reinvestment of interest/dividends. Past results are not a guarantee of future performance. See "Notes to Performance Summaries" for additional information that is an integral part of this presentation.

  40. Commercial Loans

  41. Overview • Commercial mortgages have been a staple of U.S. insurance company portfolios for over 100 years due to: • Liability Matching: Asset / liability duration matching with fixed credit spreads mitigating interest rate risk • Competitive Risk Adjusted Returns: Relative to public market alternatives, including corporate bonds • Superior Call Protection: Relative to corporate bonds, due to lock out periods and pre-payment penalties • Lower Delinquency and Severity Rates: versus corporate bonds and CMBS • Lower Volatility • Structural Benefits Versus CMBS: More lender control in loan structuring; realizing a recovery in the event of a default • Improved Risk Based Capital Treatment – Effective 2013

  42. Yield Comparison Source: Barclays, Quadrant Real Estate Advisors Note: Commercial Mortgage Loans represent privately placed whole loans (first mortgages). Total return and standard deviation calculations sourced from the Giliberto-Levy index as of 9/30/2013. Commercial mortgage yields and spreads are based on market opportunities seen by Quadrant Real Estate Advisors. The Yield represents the bond equivalent weighted spread across property types for 75% LTV loans and DSCR ranging from 1.25-1.45x.

  43. Capital Treatment Has Become More Favorable Life InsuranceCompanyRiskBased Capital Charges Commercial Mortgage RBC Charge Description Source: NAIC, AAM

  44. Widely Used Percent of Companies with CML Holdings Source: SNL, data as of 9/30/13

  45. Any Questions?

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