Higher rates need higher growth

2014 has seen the consensus of higher Treasury yields and eco-nomic activity fail to materialize. Since the taper tantrum of May-June 2013, the 10-year Treasury has settled into a range of 2.5-3.0%. For yields to break-out of the range, we need a catalyst.

Economic data has thus far failed to deliver in 2014, an impor-tant factor in the reasons for lower Treasury yields

Source: Barclays, Bloomberg, as of June 19, 2014

Nominal GDP and the 10-Year Treasury have tracked each other closely over the past fifty years

Source: St. Louis Federal Reserve as of March 31, 2014

Falling Treasury yields and risk premiums have fueled strong returns in 2014 for bonds. In this commentary, Portfolio Managers David Weis-miller, Michael Marzouk, and Bob Boyd discuss the current market envi-ronment, outlook, and portfolio positioning.

Start at the top, what is your assessment of 2014?Weismiller: Entering 2014, there was a tight consensus amongst market participants, economists, and strategists alike that U.S. growth would accelerate, interest rates would rise, and riskier as-sets would outperform. Half way through the year though, economic growth has stumbled, interest rates are lower, and credit and gov-ernment bonds are outperforming. This outperformance along with muted growth, low inflation, and accommodative central bankers continues to incentivize market participants to move further out on the risk spectrum. We think this leaves investors overexposed to du-ration risk, in particular, should U.S. growth rebound in the 2nd half of the year.

Table 1: A good year thus far; duration and credit risk outper-forming amidst a drop in yields and risk premiums

YTD Return (%) DurationEmerging Markets 6.80 5.86High Yield 5.38 3.98Corporate 4.92 7.02Agency MBS 3.56 5.16Aggregate 3.35 5.57Bank Loan 2.59 0.25

Source: Barclays, Credit Suisse, as of June 19, 2014

What happened to the consensus forecast of higher rates?Marzouk: Weak economic data, continuing slack in the labor mar-kets, and a return of geopolitical risks have each been factors in lower rates thus far in 2014. But the true driver of the current rate environ-ment have been central bank policies. We need to keep in mind that we are not playing with the same playbook we had in the past. The Fed, ECB and BOJ are each writing new, very different chapters in our economic history and that makes gauging the future based on prior

june 2014

THE INVESTOR

NAVIGATING THE CREDIT MARKETS

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data especially difficult. With the 10-year Treasury in a range be-tween 2.5-3.0%, yields are fairly valued given the level of economic activity, central bank policy, and inflation. For yields to move out of the current trading range, we need a catalyst.

Is the catalyst stronger economic activity?Weismiller: Economic activity still has the potential to surprise on the upside. Unemployment is falling and is likely to continue fall-ing. Some cite the participation rate, which is at multi-decade lows, as a source of excess labor, but the aging population may mean a good portion of this pool is out of the labor force for good. That could bring inflation back into the discussion and make the Fed’s job much more difficult. Volatility is also exceptionally low today, meaning any number of events outside expectations could move those levels sharply higher. It is an especially important time to carefully monitor risk positions.

Chart 1: Higher rates need higher growth

Source: Bloomberg, Barclays, as of June 19, 2014. The Citi Economic Surprise Index is a composite index which records economic data relative to expec-tations on a three-month rolling basis. A reading above zero indicates data above expectations.

How would you describe credit performance year-to-date? Marzouk: Returns have been consistent with the respective asset classes’ duration and credit risk. However, the recent strength in high yield bonds is inconsistent with an improving growth out-look. For example, BB and CCC rated bonds have performed inline with each other while cyclically sensitive sectors such as Metals/Mining, Chemicals, Gaming, and Retail are underperforming. Bank loan returns, while inline with market expectations of a 4-5% total return for 2014, have underperformed other sectors due to the lack of duration risk.

Much has been written about the growth of the bank loan mar-ket, in particular, floating rate mutual funds, as a potential warning sign of overvaluation?Marzouk: Investor demand and changing buyer bases are techni-cal aspects of the market and not indicative of overvaluation from a fundamental standpoint. The growth of the bank loan market has actually been quite tame relative to other sectors (Table 2). What is unique is the growth of floating rate mutual funds and the retail investor’s presence in the asset class. The growth of mutual funds and other total return investors has been to diversify the interest rate risk of traditional fixed income.

Floating rate funds have grown from $60bn a few years ago to more than $140bn today. With mutual funds now accounting for roughly 20% of the total asset base, there will be periods of vola-tility attributed to negative fund flows – something seen in other sectors with large mutual fund ownership such as high yield, mu-nicipal, and emerging markets. Those technical dislocation periods are often a great time to buy.

Table 2: Bank loan market growth has been tame compared to other fixed income asset classes over the past few years

Market Value ($bn) 2007 2010 2014Barclays High Yield Index $629 $930 $1,353CS Leveraged Loan Index $644 $619 $886Barclays USD EM Index $336 $536 $1,423Barclays Aggregate Index $10,109 $13,133 $17,082Barclays U.S. Corporate Index $1,978 $2,843 $3,986

Source: Barclays, Credit Suisse. Indices total market value as of December for 2007, 2010 and May 31st for 2014.

Boyd: While we have seen reduced floating rate fund flows, CLO issuance year-to-date has eclipsed $56bn, already the fourth high-est year on record, and easily absorbing the $5bn in outflows seen from mutual funds. During the month of May, 20 new U.S. CLOs priced totaling $11.8bn, the third largest volume on record. With CLO issuance expected to remain high in 2014, the technical pic-ture for bank loans remains robust. Bank loans this year have been like a child’s roller coaster - lots of screaming (headlines), but mostly a pretty tame ride.

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Chart 2: CLO Issuance has been robust in 2014, leading to strong demand and favorable technicals for bank loansMonthly CLO issuance and mutual fund flows

Source: JP Morgan, as of May 31, 2014

Turning to credit fundamentals, defaults and credit risk have been benign for some time, has anything changed?Weismiller: Over the past couple years we’ve seen balance sheet deleveraging and overall corporate conservatism. It remains a consistent story today; profit margins and cash flows are healthy, balance sheets are strong, and capital markets robust. Thus, de-fault risk is muted, providing some validation, from a fundamental standpoint, for the credit spreads we see today. However, over the last several quarters we have begun to enter the releveraging phase of the credit cycle, in particular through M&A activity. Shareholder focus is increasing as companies struggle to grow top-line revenue in a 2% GDP environment.

Wouldn’t M&A activity be indicative of late cycle behavior?Marzouk: In the past, often yes, but this cycle has been far from traditional. The M&A focus has been on synergistic strategic ac-quisitions versus the debt intensive Leveraged Buyout (LBO). The composition of the buyers (mostly investment grade companies in-stead of private equity), strength of corporate balance sheets and open capital market conditions means today’s M&A activity does not necessarily mean the end of the credit cycle.

What is the state of the high yield market today, are yields and spreads too low?Boyd: High yield bonds have once again surprised to the upside in 2014 with returns that are unlikely to be repeated in the sec-ond half of the year. In some respects, it’s difficult to benchmark today’s high yield market versus prior cycles. Absolute yields are at all-time lows, but this is partially a reflection of lower overall rates that have been largely engineered by the Federal Reserve. If we instead look at the market on an Option Adjusted Spread basis

(our preferred measure), credit spreads are at post-Great Reces-sion lows, but still a good distance from the all-time low. Corporate fundamentals and low expected default rates support tighter-than-average high yield credit spreads, although given the rally year-to-date, duration risk should be closely monitored.

So how do you position high yield portfolios today?Boyd: We believe that despite the lower interest rates we’ve seen so far in 2014, the bias is for higher rates over the medium-term. Thus, we see little value in 10-year high yield bonds with low 5% coupons and have substituted bank loans for longer duration secu-rities. Overall, we have positioned our portfolios with less interest rate risk and more credit risk to realize both lower duration and higher yields. As always, we are primarily focused on issuer selec-tion and have pared back our total number of positions to best take advantage of what we expect will be a continued low default rate environment.

Across multi-credit strategies, how are you positioned? Weismiller: Year-to-date, the rate rally has led to strong total re-turns and significantly lower yields for investment grade and high yield bonds. At the same time, bank loans have not participated in the strong excess returns, given their lack of duration risk. Thus, we find bank loans to have relative value and continue to keep an overweight exposure. With bank loan and high yield bond yields equivalent (Chart 3), one is not giving up significant income to move senior in the capital structure while also reducing portfolio duration and interest rate risk. We find this especially compelling in evaluating BB rated bank loans and high yield bonds.

Chart 3: High yield bonds and bank loans converge again

Source: Credit Suisse, Barclays, as of June 18, 2014

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ABOUT PACIFIC ASSET MANAGEMENTFounded in 2007, Pacific Asset Management specializes in credit oriented fixed income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC registered investment adviser and a wholly owned subsidiary of Pacific Life Insurance Company (Pacific Life). As of March 31, 2014 Pacific Asset Manage-ment managed approximately $4.7bn. Assets managed by Pacific Asset Management includes assets managed at Pacific Life by the investment professionals of Pacific Asset Management.

IMPORTANT NOTES AND DISCLOSURESBank loan, corporate securities, and high yield bonds involve risk of default on interest and principal payments or price changes due to changes in credit quality of the borrower, among other risks. Pacific Asset Management is an investment advisor; it provides investment advisory services to institutional clients and does not sell se-curities. Pacific Select Distributors, Inc. is the distributor for Pacific Life’s retail products. Pacific Asset Management and Pacific Select Distributors, Inc. are each a wholly owned subsidiary of Pacific Life.

This information is presented for informational purposes only. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole investment making decision. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions, are subject to change without notice. Investors should consider the investment objectives, risks, charges and expenses carefully before investing. Please read the applicable prospectus or other offering documents carefully before investing. For this and more complete information about the available investment vehicles, investors should contact their financial advisor, consultant or visit www.pacificlife.com or www.pam.pacificlife.com. FOR MORE INFORMATIONPacific Asset Management • 700 Newport Center Drive • Newport Beach, CA 92660 • www.pam.pacificlife.com

Federal Reserve

Boyd: From a sector standpoint, we continue to emphasize areas that will benefit from a gradual, sustained economic recovery. Lodging and gaming remain overweights as higher income con-sumers switch from balance sheet repair to more discretionary spending. Building materials and energy production related com-panies are also overweights as they are benefitting from additional capital spending. We are cautious on sectors in secular decline such as wireline telecom and technology companies where obsolescence are high risks.

What specific risks do you see in the credit markets?Weismiller: First, the rate rally and substantial returns seen year-to-date are probably leading to some investor complacency, with small margins for error should rate volatility present itself again. While strong fundamentals should support credit spreads, dura-tion risk is more prevalent, especially with the hopes of a second half improvement in data.

Second, shareholder activism and M&A activity needs to be moni-tored. We are in a period of the cycle where corporate boards are becoming more comfortable taking risk to grow their businesses. As a result, we’ve seen a pick-up in hiring, capital expenditures, and most notably, a pick-up in dividends, share buybacks, and M&A activity. Balance sheets, flush with cash, are now ripe for share-holder use. As the credit cycle progresses, we must be mindful of companies and sectors more prone to favoring shareholders over bond holders.

Summary: Year-to-date, lower risk premiums combined with fall-ing Treasury yields have led to significant total returns from both duration and credit sensitive asset classes. With Treasury yields range bound and economic activity failing to surprise to the up-side, credit markets remain in the sweet spot of modest economic growth and accommodative monetary policy. With this backdrop, complacency has set in towards risk premiums and interest rates, leading us to favor a more neutral risk allocation relative to bench-marks and less duration sensitive sectors.

Pacific Asset ManagementJune 2014