The Case for A Rated Issuers

Transcription

1 The Case for A Rated Issuers August 31, 2012 PFM Asset Management LLC One Keystone Plaza, Suite 300 N. Front & Market Sts Harrisburg, PA (717)

2 Contents Tab I Overview of the Corporate Market Tab II PFM Credit Process Tab III Moody s and S&P Methodology Tab IV PFM Recommendations 1

3 Tab I 2

4 Challenges The universe of AAA and AA issuers is small and shrinking Relative to Agencies, AAA and AA issues generally don t offer high enough yields over Treasuries to warrant taking on the additional credit risk (trade expensively relative to Agencies) Many sectors are available only (or mostly) in the A category In particular: banks and financial companies 3

5 Actual Dollars Millions Actual Dollars Billions Corporate Fundamentals are Strengthening S&P 500 Earnings per Share Corporate Profits $100 $90 $80 $70 $60 $50 $40 $30 $20 $10 $- 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $ $1,050 S&P 500 Trailing 12-Month Sales per Share Aggregate Quarterly Cash & Short-term Investments Balances S&P 500 $1,000 $950 $900 $850 $800 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q Source: Bloomberg, Bureau of Economic Analysis, FactSet 4

6 Investment Grade Ratings Definitions S&P s Rating Moody s Rating Fitch s Rating AAA Aaa AAA AA Aa AA A A A BBB Baa BBB BB Ba BB B B B CCC Caa CCC CC Ca CC C C C Definitions Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. Obligations rated Aa are judged to be of high quality and are subject to very low credit risk. Obligations rated A are considered upper-medium grade and are subject to low credit risk. Obligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics. Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk. Obligations rated B are considered speculative and are subject to high credit risk. Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk. Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. Obligations rated C are the lowest rated class and are typically in default, with little prospect for recovery of principal or interest. Source: Moody s Investor Services 5

7 The Corporate Ratings Landscape Continues to Evolve Downgrades spiked during the financial crisis and remain elevated 2,500 2,000 Moody's - Upgrades Moody's - Downgrades Moody s Upgrades and Downgrades ,658 2,193 1,500 1, Source: Moody s Investor Services 6

8 Availability The number of AAA and AA rated companies has declined significantly over the past 2 decades Recently, the decline has primarily occurred in the financial sector, a result of the impact of the financial crisis Ratings on industrial companies are historically typically lower than financials but are usually more stable Rating Allocation Percentages of the 1-3 Year Corporate Index Rating 3/31/1997 3/31/2002 3/31/2007 3/31/2012 AAA-AA 21% 25% 42% 19% A 54% 39% 35% 52% BBB 25% 36% 23% 29% Source: Merrill Lynch Global Indexes, 1-3 Year Corporate Index 7

9 Diversification AA rating threshold impacts ability to diversify Diversification: A large portion of AAA and AA rated corporate issuers are in the financial sector Limiting purchases to AAA and AA may result in over exposure to the financial sector Rating Allocation Percentages of the 1-3 Year Corporate Index (Sector)* Financial Industrial Utilities A-AAA 38.5% 29.5% 2.8% AAA 1.2% 1.0% 0.0% AA 12.0% 4.9% 0.1% A 25.3% 23.6% 2.7% BBB 5.1% 21.3% 2.4% * Totals may not add up to 100% because table ignores cash holdings of the index. Source: Merrill Lynch Global Indexes, 1-3 Year Corporate Index 8

10 Valuation Approved AAA and AA Rated Issuers AAA and AA rated industrials offer less value than A rated industrials 1 Issuer S&P Moody s Fitch Example Security Yield Spread to Agency Exxon AAA Aaa NR Chevron AA Aa1 NR Proctor Gamble AA- Aa3 NR 3M AA- Aa3 NR Johnson & Johnson AAA Aaa AAA Wal-Mart AA Aa2 AA XOM /2014 CVX /2014 PG /2014 MMM /2013 JNJ /2014 WMT / % +0.10% 0.46% +0.13% 0.39% +0.03% 0.33% +0.05% 0.30% +0.01% 0.59% +0.16% 1 See important disclosures at the end of this presentation. Source: Bloomberg, as of 7/11/2012 9

11 Valuation Approved A Rated Issuers Recommended PFM approved issuers rated A by a least one rating Agency 1 Issuer S&P Moody s Fitch Example Security Yield Spread to Agency Caterpillar A A2 A Deere & Company CAT / % +0.25% A A2 NR DE / % +0.27% General Electric AA+ A1 NR GE / % +1.03% IBM Corp A+ Aa3 Aa3 IBM / % +0.24% Merck & Co AA Aa3 A+ MRK / % +0.43% Pfizer Inc. AA A1 A+ PFE / % +0.26% Issuers on PFM s approved list are subjected to our credit review and approval process 1 See important disclosures at the end of this presentation. Source: Bloomberg, as of 7/11/

12 A Rated Industrials May Help Limit Volatility Return: Exposure to the Industrial sector may reduce volatility of returns 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% U.S. Industrials 1-3 yr U.S. Financials 1-3 yr Industrial and Financial Corporate Sector Annual Returns Std. Dev. of Industrials Std. Dev. of Financials 0.61% 0.52% 0.48% 0.31% 0.26% 0.32% 1.68% 0.80% 0.36% 0.31% 0.60% 0.60% 0.52% 0.35% 0.26% 0.27% 2.82% 2.05% 0.59% 0.61% 0.01% -0.08% -0.04% -0.04% 0.00% 0.05% -1.14% -1.25% -0.23% -0.30% Returns for periods ended December 31 st Sector 1 Year 3 Years 5 Years 10 Years Industrial 2.30% 6.71% 5.36% 4.70% Financial 1.10% 7.46% 4.21% 4.13% Difference +1.20% -0.76% +1.15% +0.58% Source: Merrill Lynch Global Indexes, 1-3 Year Industrials Index, 1-3 Year Financials Index 11

13 A Rated Industrials May Help Limit Volatility Return: Exposure to the Industrial sector may reduce volatility of returns 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% Industrial and Financial Corporate Sector Annual Returns U.S. Industrials 1-3 yr U.S. Financials 1-3 yr -10.0% Std. Dev. of Industrials Std. Dev. of Financials * 0.61% 0.52% 0.48% 0.31% 0.26% 0.32% 1.68% 0.80% 0.36% 0.31% 0.25% 0.60% 0.60% 0.52% 0.35% 0.26% 0.27% 2.82% 2.05% 0.59% 0.61% 0.63% 0.01% -0.08% -0.04% -0.04% 0.00% 0.05% -1.14% -1.25% -0.23% -0.30% -0.38% Returns for periods ended June 30 th Sector 1 Year 3 Years 5 Years 10 Years Industrial 2.06% 4.13% 5.17% 4.73% Financial 2.53% 5.72% 4.40% 4.17% Difference -0.47% -1.58% +0.77% +0.56% * Data through 6/30/2012 Source: Merrill Lynch Global Indexes, 1-3 Year Industrials Index, 1-3 Year Financials Index 12

14 Performance of 1-3 Year Corporate Indices 12.0% Index Yields Merrill Lynch 1-3 Year Corporate Indices 10.0% AAA A AA BBB 8.0% 6.0% 4.0% 2.0% 0.0% Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun % 1.73% 1.12% 0.92% Source: Merrill Lynch Global Indexes, 1-3 Year Corporate Index 13

15 PFMAM Recommendation For Your Consideration and Approval.. Allowing Corporates with A Ratings May: Provide for greater diversification Increase the opportunity set Offer higher initial yields Provide for greater return potential (without increased portfolio risk) 14

16 Tab II 15

17 Credit Analysis and Monitoring Process PFM s Credit Committee researches every potential issuer Independent research is fundamental credit ratings are secondary Detailed review of the issuer is completed before approval Credit Committee: Chief Credit Officer, Chief Investment Officer, portfolio managers, traders, research analysts and includes participation by compliance Bloomberg MarketAxess Tradeweb Information Sources: Independent research Company releases Sell side analysis News releases Company financials Ratings reports Security valuation Approved Issuer List Universe of Potential Issuers Preliminary Screen Minimum rating requirements Availability of supply Relative value analysis Economic outlook Outlook for industry growth Geographic exposure Changes in regulatory environment Improving or stable ratings Diversity of revenue/profits Capital structure Strength of financial position Leader in industry Superior product Management team Industry Screen Issuer Screen 16

18 PFM s Pragmatic Credit Process Credit Committee: Responsible for developing and maintaining approved credit list Members include PFM s Chief Credit Officer, CIO, portfolio managers, traders, research analysts and includes participation by Compliance Pragmatic approach that focuses on market events and security price tracking Early warning system drives proactive credit decisions Quantitative Analysis Balance sheet analysis Earnings: actual and projections Asset quality and impairments Price movement of fixed-income and equity securities Monitor credit default swap levels Trading volume Dividend and capital policies Qualitative Analysis Industry trends Competitive environment Business cycle Corporate governance Regulatory environment Analysts recommendations Rating agency actions News releases 17

19 Avoiding Credit Pitfalls PFM helped clients avoid potential problems during the recent credit crisis Company November 1, 2007 S&P / Moody s Ratings December 31, 2009 S&P / Moody s Ratings PFM s Action Lehman Brothers A+/A1 Default, Not Rated/ Default/Withdrawn Last held 5/12/06 Washington Mutual A-/A2 Default, Not Rated/ Default/Withdrawn Rejected by Credit Committee American General Finance A+/A1 B/B2 Rejected by Credit Committee International Lease Finance AA-/A1 BB+/B1 Rejected by Credit Committee CIT Group A/A2 Default-NR/Default-NR Rejected by Credit Committee MBIA AA/Aa2 BB-/Ba3 Never purchased Reserve Primary Fund AAAm Fund liquidated Never recommended 18

20 Approved Credit List Credit Committee: Add, Remove, or Place Issuer on Hold Issuers must be approved before any security can be purchased Reviews of approved issuers are triggered by: Anniversary Industry specific events Credit specific events ML 1-3 Year Corporate Universe (as of March 31, 2012) 468 issuers Rating # of Issuers % of Issuers AAA 8 1.7% AA % A % BBB % Exclude BBB-rated credits Assess/screen sovereign & currency risk Detailed credit review process PFM s Approved Issuer List 49 Short-term issuers 28 Long-term issuers 19

21 Tab III 20

22 S&P s Credit Rating Methodology Industry Risk The relationship of the industry to the economy and the possible impact of various economic scenarios, including the ramifications of legislation Asset Quality An analysis of the composition of the portfolio regarding type, mix, and diversity of receivables, and evaluation of growth prospects Non-Finance Activities An analysis of the risks and prospects of any non-finance-related businesses, as well as analysis of any future diversification plans (like acquisitions and divestitures) Capitalization Analysis of capital leverage, debt maturity, and financing requirements Asset-Liability Management Examination of the company's philosophy and management of assets and liabilities, regarding maturity and interest rate sensitivity Source: Standard & Poor s 21

23 S&P s Credit Rating Methodology cont d Profitability Review of the company's performance based on profitability measures growth, yields, spreads, and returns Ownership/Affiliation Discussion of the degree of strength derived from parent support Management Evaluation of management's performance, policies, controls, planning, and depth Accounting Analysis of accounting methods and comparison with industry practices Source: Standard & Poor s 22

24 Moody s Credit Rating Methodology Non-Financial Factors Franchise Positioning o Market Position and Sustainability o Operational Diversification Risk Positioning Potential Volatility of Assets and/or Cash Flows Governance and Management Quality Risk Management Key Relationship Concentrations Liquidity Management Operating Environment Economic Strength Institutional Strength Susceptibility to Event Risk Financial Factors Profitability Liquidity Capital Adequacy Asset Quality Source: Moody s Investors Service 23

25 Moody s Changes its Methodology On March 19 th, Moody s modified its Finance Company Global Rating Methodology to incorporate the insights it has gained from the financial crisis regarding the level and stability of finance companies credit quality The new methodology places additional emphasis on: Meaningful regional and business model differences Reliance on wholesale funding o Vulnerability to fluctuations in investor confidence relating to a given firm s creditworthiness o Vulnerability to funding conditions in the general market Asset and cash flow volatility Source: Moody s Investor Services 24

26 Results of Moody s Methodology Changes Permanently lower ratings for many financial institutions Due to more stringent ratings criteria, even if financial metrics return to their pre-crisis levels, many financial firms will not see their rating upgraded Bank downgrades likely in 2012 Moody's expects to place a number of banks under review for downgrade in the first quarter of 2012 Adverse climate for banks from o deteriorating sovereign creditworthiness o elevated economic uncertainty o elevated funding spreads European banks and global capital market intermediaries (broker/dealers) are likely to be impacted the most Standalone credit assessments for broker/dealers will be lowered on average form the single-a range to Baa-range Source: Moody s Investor Services 25

27 Tab IV 26

28 What does PFM recommend for Palm Beach County School District? For Your Consideration and Approval.. Recommended Investment Policy Language: H. Corporate Notes. The Cash Manager may invest in corporate notes issued by corporations organized and operating within the United States or by depository institutions licensed by the United States that have a long-term debt rating, at the time of purchase, at a minimum single A category by any two nationally recognized statistical rating organizations ( NRSROs ). A maximum of 15% of available funds may be directly invested in corporate notes. A maximum of 5% of available funds may be invested with any one issuer. The maximum length to maturity for corporate notes shall be five (5) years from the date of purchase. 27

29 Disclaimer This material is based on information obtained from sources generally believed to be reliable and available to the public; however, PFM Asset Management LLC (PFMAM) cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities. The information provided in this presentation related to Approved Issuers (the List ) is general in nature only and has not been prepared taking into consideration your particular needs, circumstances or objectives. The List is dynamic and does not always represent current views, nor do we have the ability to timely transmit views by sending new lists. The List does not convey all relevant information that some should take into account in making investment decisions. PFMAM recommends you read its Disclosure Brochure a/k/a Form ADV, Parts 2A & B which is available by calling the PFMAM Compliance Group at (717) or by sending an to ComplianceGroup@pfm.com 28