A View January 2018 from the Desk In This Issue: Trading Trends... 1 Looking Forward... 3 About Us: We offer financial institutions a comprehensive solution that includes balance sheet management, investment banking, and capital markets. Our broad range of services combined with our personal service and professional advice can help you improve your institution s financial performance and achieve your strategic objectives. We have built our process from the ground up to deliver Wall Street Execution with Main Street Customer Service. Trading volumes in 2017 were generally lower across the board compared to previous years. This can be easily explained by placing clients that were uncharacteristically quiet into three general categories. The first group is clients that saw strong loan demand absorb most of their excess liquidity. A second group of clients that are usually strategy-driven remained sidelined, as 2017 yielded fewer compelling market opportunities to reposition the portfolio than years past. A final subset of clients spent much of the year in a holding pattern while they tried to determine the effects of tax reform on the municipal debt market and Treasuries in general. Although these factors led to somewhat choppy trading volumes in 2017, it is still beneficial to review the trading trends we witnessed to help us prepare for 2018. Trading Trends: Figure 1 on the next page is a bar chart showing various fixed-income asset classes and the percentage of client purchases falling into each category on a monthly basis. In six of the first seven months of the year, MBS were the most actively purchased asset class. Although MBS purchases dwindled in the second half of the year, activity in the beginning of the year was enough to make this the most actively purchased asset class in 2017, totaling 31.74% of client purchases. This trend makes sense, as those clients that needed to put excess liquidity to work were looking for securities with stable cash-flow profiles to help fund future loan growth. Bank qualified (BQ) supply came in at $17.762 billion in 2017, down 23% from 2016 and down 53% from the recent high-water mark in 2010. Even lower supply, coupled with the tax uncertainties referenced above, couldn t keep some market participants away from tax-exempt munis. After yields cheapened in the second half of the year, increased demand for longer duration assets with higher relative yields made this the most continued on page 2 January 2018 1
Figure 1: Client Purchases: Asset Class Breakdown Figure 1 shows various fixed income asset classes and the percent of client purchases falling into each category. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC 2017 TOTALS Treasuries Taxable Muni Tax Exempt Muni Other MBS Corporate CMO Agency actively purchased asset class in four of the last five months of the year. Ultimately, tax-exempt munis finished a close second to MBS, coming in at 29.71% of total client purchases. On the contrary, taxable muni purchases ended the year at only 1.66% of total purchases, which was extremely low. Bucking the trend in the BQ market, taxable issuance has increased in each of the last three years. Supply came in at $32.473 billion, up 15% from 2016 and up 50% from the recent low-water mark in 2014. This trend could continue, as the expectation is that tax-exempt issuance will decrease given tax reform, and taxable issuance will fill the void. A fresh supply of taxable issuance could drive trading activity in this asset class in 2018. Agency purchases were much higher than in years past, as clients found value in significantly discounted callable agencies with positive option-adjusted spreads. These issues offer positive convexity, allow for a spread pickup to bullets and have the potential for large yield-to-call if rates move significant lower from here. This was the most actively purchased asset class in two months, and it came in third in the year at 18.01%. Corporates totaled 11.90% in 2017, which was light compared to years past. This reduction is not surprising, as continued spread-tightening made attractive opportunities harder to come by. Bloomberg s A-rated 10-year corporate curve ended 2017 with a spread just 82 basis points (bps) over Treasuries, which is within 2 bps of the closing low dating back to 2009. A similar trend can be seen on the 5-year part of the curve, where spreads ended the year within 7 bps of the low dating back to 2009. Spread-tightening is especially evident in the community bank debt space. For clients that participated, this has been one of the best performing asset classes over the past couple years, fueled by an uptick in merger and acquisition activity, an increased depth of market participants, and general credit spread tightening. Some investors are using the recent performance in their community bank portfolio to harvest gains in issues that may have tightened significantly, often as a result of an acquisition, in order to free up capacity to add other issues. Although spreads have tightened, if the market remains healthy, we could see much of the same in 2018 as yields are still attractive and trading well above large traditional corporate issuance. continued on page 3 January 2018 2
Figure 2 shows various fixed income asset classes and the percent of client sales falling into each category. Figure 2 shows the monthly breakdown of client sales by asset class. Given lighter trading volume and the lack of compelling strategies referenced above, the monthly breakdowns are especially erratic in 2017. The large amount of tax-exempt sales in January came as clients looked to take advantage of supply/demand imbalances and get out in front of potential tax reform. Another reoccurring theme was reducing exposure to credit risk given tightening spreads. Some clients took credit risk off the table by reducing exposure to the asset class and others opted to sell issues where spreads had tightened significantly to free up corporate capacity to add higher yielding community bank debt issues. This caused corporates to be the most actively sold asset class in four months and the second most actively sold in the year at 26.14%. Figure 2: Client Sales: Asset Class Breakdown 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC 2017 TOTALS Treasuries Taxable Muni Tax Exempt Muni Other MBS Corporate CMO Agency Another trend, which can t be easily seen from Figure 2, involved selling out of securities on the short end of the curve where they are most susceptible to Federal Open Market Committee (FOMC) rate increases. Clients often sold fixed assets, maturing in three years or less, to prevent further market price erosion from Fed tightening. This liquidity was then redeployed into a mix of floating-rate assets and longer-duration assets as part of a barbell strategy or used to fund loan demand. Looking Forward: 2017 proved to be a great year for equity investors. The Dow Jones Industrial Average, S&P 500, and NASDQ all reached new all-time closing highs. Specifically, excluding dividends, the S&P 500 appreciated by 19.42%, while the Dow Jones Industrial Average was up 25.08% and the NASDQ was up 28.24%. The picture wasn t quite so rosy for bond investors, especially depending on the asset class and part of the curve in which they were investing. Although many market participants over the past few years have been warning investors to stay short on the curve to minimize duration and protect market values in case of rising rates, this has led to a difficult year for portfolio managers who heeded this advice. continued on page 4 January 2018 3
As we begin 2018, we are happy that tax reform is behind us and that we can digest the changes to assist our clients with any balance sheet repositioning that is necessary. In general, longer-duration assets outperformed fixed-rate assets on the short end of the curve. Specifically, the 30-year Treasury yield dropped by 33 bps while the 10-year Treasury dropped by 4 bps in 2017. In contrast, the yield on the 2-year Treasury rose by 70 bps, leading to market price erosion for short securities. Although yields on the short end of the curve look enticing given the recent movement, we are still reluctant to enter this part of the curve with guidance suggesting the Fed will increase Fed Funds three times in 2018. Instead, we continue our recommendation that clients avoid the short end of the curve and instead focus on a mix of LIBOR- or Prime-based floaters paired with longer-duration assets. Clients that purchased LIBOR floaters throughout the year have seen interest rates reset higher, as 1-month LIBOR has increased by almost 80 bps in 2017 alone. If guidance is correct and three more hikes are on the table in 2018, these investments should continue to perform well, even for clients just entering the space now. For clients that were buying assets on the long end of the curve, munis had a volatile year leading up to tax reform. Even so, the 10-year BQ AA-rated curve ended the year around 25 bps lower than where it started the year, but uncertainties remain. Logically, a decrease in federal tax rates would result in higher nominal muni yields in order to equalize the taxable equivalent yields pre- and post-tax reform. However, this fails to take into account supply and demand changes. As referenced above, the decrease in federal tax rates could create a large supply imbalance, caused by less tax-exempt supply and more taxable supply. This phenomenon fueled buying in the final weeks of 2017, and could actually cause the asset class to tighten in the face of tax reform. As we begin 2018, we are happy that tax reform is behind us and that we can digest the changes to assist our clients with any balance sheet repositioning that is necessary. Also, an uptick in volatility would be a welcome sign as volatility often brings out some of the best market opportunities. This proved to be a problem in 2017 as both Merrill Lynch s MOVE Index and the CBOE Volatility (VIX) Index traded at the lowest level ever. If this trend reverses course, hopefully it will present new portfolio opportunities. We must continue to stay mindful of where we invest on the curve and how FOMC rate decisions can affect these investments. We look forward to assisting our clients as they navigate the market amidst a changing landscape in 2018. Joshua A. Albright, CFA Ryan G. Epler Mark B. Trinkle January 2018 4
THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA 18104 610.351.1633 6010 Executive Blvd. Suite 503 Rockville, MD 20852 240.242.4083 Chicago Mercantile Exchange 30 South Wacker Drive 22nd Floor Chicago, IL 60606 312.466.7646 Joshua A. Albright, CFA Allen R. Collins Executive Vice President Chief Compliance Officer Arnold G. Danielson Chairman Emeritus Danielson David G. Danielson Executive Director Ryan G. Epler Charles Gorman Associate Strategic Analyst Mike Harrison Director Strategic Advisor Mark A. Neff Karl J. Ostby Strategic Advisor Robert J. Pachence, Jr. Co-Founder & Managing Principal Jack E. Payne, CFA, CFP Finance & Operations John Putman Director of Analytics Michael Rasmussen Matthew T. Resch, CFA Co-Founder & Managing Principal Eric Tesche Executive Director Mark B. Trinkle John S. Walker, Ph.D., CFA Chief Economist Ryan Walker Associate Strategic Analyst Rick Weiss Chief Bank Strategist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at 610.351.1633. 2018 Ambassador Financial Group, Inc. Important Disclosure: Ambassador Financial Group does and seeks to do business with companies included in this report. As a result, readers should be aware that the firm may have a conflict of interest that could affect the objectivity of the report. January 2018 5