Government Investment Officer’s Association2019 Annual ConferenceAsset-Backed Securities and Corporate Notes

March 20, 2019

Jim Womack, CFAManaging Director-Fixed Income, Principal

Asset-Backed Securities and Corporate NotesThe Quest For Yield (Spread): The ONLY Reason We Look At Non-Treasuries

SPREAD!

Time

Yie

ld

US Treasury Yield Curve

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Highest Quality Aaa AAA 2%(Smallest Degree of Credit Risk)

High Quality Aa AA 15%(Small Degree of Credit Risk)

Upper Medium Grade A A 46%(Largest Rating Category)

Medium Grade Baa BBB 37%(Neither Well Protected or Speculative)

83% Rated‘A’ or ‘BBB’

Corporate NotesCorporate Investors Get Paid Spread Primarily For Taking on Credit Risk

Moody’s S&P Weight*

* Credit weights by market value within the Bloomberg Barclays 1-3 Year Corporate Bond Index

12 Bonds Rated ‘AAA’

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Corporate NotesWhat Is Credit Risk? There Are Three Answers That All Boil Down to Losses

Downgrade Risk

Default Risk

Price Volatility Risk

THIS DOES HAPPEN! But its been a long time since average default rates have moved up much, so investors have/can get complacent.

Most investors have a minimum credit guideline. When a bond rating falls below the minimum, it generally results in a forced sale, often after values have declined.

Even without a downgrade, company specific business conditions can rapidly change asset valuations. For bond investors, it’s usually to the downside…after all, a bond matures at par!

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90

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Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 Mar-19

GE Bond Price (GE 2.7% 10/09/2022)

General Electric’s Story:

Deteriorating business conditions, most recently in the Power Generation segment.

Leverage ratios (e.g., Net debt/EBITDA, etc.) moving up.

SEC is widening its probe of certain accounting treatments used by GE in its power business.

GE using asset sales to reduce debt, this results in declining revenue and cash flow remains challenged…stay tuned!

Corporate NotesGeneral Electric: A Recent Example of Corporate Credit Risk

Pric

e in

Dol

lars

S&P Downgrades to BBB

General Electric 2.7% 10/9/22

Duration: 3.6 years

2018 Price Change: (7%)2018 Peak Decline: (12%)

GE Credit Rating (Standard & Poor’s)

0

1

2

3

4

5

1990 1994 1998 2002 2006 2010 2014 2018

AAA

AA

A

BBB

JUNK

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Corporate NotesMitigating Risk: Guidelines Should Be Developed Before Investing

Most Guidelines Specify: Maximum MaturityMinimum Credit RatingMaximum Issue Size

Important to Consider: Maximum Issuer ConcentrationMaximum Industry AllocationMinimum Outstanding Issue SizeSector Duration Targets

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Corporate NotesMaximum Issuer Concentration: The All-The-Eggs in One Basket Deal

New Jersey Bell 8.0% 06/01/2022

GTE Inc. 8.75% 11/01/2021

Alltel Corp 6.8% 05/01/2029

Verizon Communications 8.75% 11/01/2021

BNSF Railway Co 6.55% 01/01/2020

The Lubrizol Corp. 7.25% 6/15/2025

MidAmerican Energy Co 3.1% 05/01/2027

Northern Natural Gas Co 4.25% 6/01/2021

Northern Pacific Railway Co 3.0% 01/01/2047

PacifiCorp 6.75% 10/26/2023

Precision Castparts Corp 2.5% 01/15/2023

Sierra Pacific Power Co 3.375% 8/15/2023

GEICO Corp 7.35% 7/15/2023

Finial Holdings Inc. 7.125% 10/15/2023

MidAmerican Energy Co 3.1% 05/01/2027

Northern Natural Gas Co 4.25% 6/01/2021

Limiting Exposure to an Issuer is SMART! ADiversified Portfolio Can Protect You In An Economic Downturn Or If A Specific Company Gets Into Trouble

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New Jersey Bell 8.0% 06/01/2022

Alltel Corp 6.8% 05/01/2029

PacifiCorp 6.75% 10/26/2023

Precision Castparts Corp 2.5% 01/15/2023

Sierra Pacific Power Co 3.375% 8/15/2023

Finial Holdings Inc. 7.125% 10/15/2023

Northern Natural Gas Co 4.25% 6/01/2021

Northern Pacific Railway Co 3.0% 01/01/2047

Verizon Communications 8.75% 11/01/2021

Corporate NotesMaximum Issuer Concentration: The All-The-Eggs in One Basket Deal

GTE Inc. 8.75% 11/01/2021

BNSF Railway Co 6.55% 01/01/2020

The Lubrizol Corp. 7.25% 6/15/2025

MidAmerican Energy Co 3.1% 05/01/2027

Northern Natural Gas Co 4.25% 6/01/2021

GEICO Corp 7.35% 7/15/2023

MidAmerican Energy Co 3.1% 05/01/2027

But Always Look Under the Hood,There Are Only Two Different Issuers On This Page!

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Corporate NotesMaximum Industry Allocation: Goal is Capital Preservation, Liquidity, Income…

BofA Merrill Lynch 1-3 Year A-AAA Corporate Bond Index:

Percent bySector Market Value

Financials 57%

Industrials 40%

Utility 3%

Percent ofSector Issuers

Financials 38%

Industrials 52%

Utility 10%

Important to Consider If Index Composition Is At Odds With Your Primary Objectives

Index Using Market Weight Index Using Equal Weight

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Corporate NotesMaximum Industry Allocation: Goal is Capital Preservation, Liquidity, Income…

Industrials: 40%

Automotive 5.6%Basic Industry 1.3%Capital Goods 4.3%Consumer Goods 3.8%Energy 6.9%Healthcare 4.0%Leisure 0.1%Media 2.0%Real Estate 1.0%Retail 2.2%Services 0.3%Technology & Elect 7.4%Telecommunications 0.5%Transportation 0.6%

Financials: 57%

Banking 51.3%Financial Services 2.0%Insurance 3.8%

Utilities: 3%

Electric - Dist. / Trans 0.4%Electric – Generation 0.2%Electric- Integrated 2.2%

Much greater diversification within Industrials vs. Financials

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Corporate NotesMinimum Outstanding Issue Size: When to Say When…$500 Million?

BofA Merrill Lynch 1-3 Year A-AAA Corporate Bond Index:

20%<$500mm

80%>$500mm

Issues by Size Market Value by SizeCharacteristics of

Less Than $500 MM

7%7%

Utility 26%Financial

51%Industrial

93%>$500mm

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Corporate NotesMinimum Outstanding Issue Size: When to Say When…$1 Billion?

BofA Merrill Lynch 1-3 Year A-AAA Corporate Bond Index:

57%<$1 Billion

43%>$1 Billion

Issues by Size Market Value by SizeCharacteristics of

Index Over $1 Billion

0%Utility

65%Financial

35%Industrial

57%>$1 Billion

43%<$1 Billion

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Corporate NotesSector Duration Target: Don’t Fall Too Much In Love With Spread

Time

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US TreasuryYield Curve

CorporateSpread Curve

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Corporate NotesSector Duration Target: Don’t Fall Too Much In Love With Spread

Overall Duration

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US TreasuryYield Curve

CorporateSpread Curve

Overall DurationY

ield

US TreasuryYield Curve

CorporateSpread Curve

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Corporate NotesSector Duration Target: PS: Holding Only Short Bonds Won’t Help In a Default

Which of These Investors Owned Lehman1-Year Paper vs Long Bonds?

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Corporate NotesBeyond Credit Analysis: Other Issues to Be Aware Of Before Pulling the Trigger

Senior vs. Subordinated Debt(Typically Associated with Financials)

Subsidiaries(e.g., Industrials with Finance Co., Utilities, etc.)

Make Whole Calls(What?)

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Corporate NotesBeyond Credit Analysis: Senior vs. Subordinated Bonds ( Just Be Aware)

Wells Fargo Corporate Bond Wells Fargo Corporate Bond

Two Wells Fargo Bonds With Different Credit Ratings…The Wells Fargo Bond on the Right Isn’t “Cheap” After All

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1) Pull up Bond2) Type DDIS <go>3) Set “Breakdown

By” to “Payment Rank, and hit <go>

Corporate NotesBeyond Credit Analysis: Senior vs. Subordinated Bonds ( Just Be Aware)

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Corporate NotesBeyond Credit Analysis: Subsidiaries ( Just Be Aware)

General Electric Corporate Bond General Electric Corporate Bond

Not Seen As Much Today (Post the Financial Crisis)But Still Common in the Utility and Telecom Sectors…Be Sure You Understand Exactly What You’re Buying

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Corporate NotesBeyond Credit Analysis: The Make Whole Call (MWC)…Just Be Aware

Could This Possibly Be a Big Deal? Yep

Originally intended as a sweetener for bondholders.

About 1/3rd of corporate bonds have an MWC feature.

Low MWC spreads resulted in few issuers exercising their call option…investors really never thought of these as callable bonds.

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0

25

50

75

100

125

150

175

2010 2012 2014 2016 2018

A-AAA Corporate Spreads (0-1 Year)

Bas

is P

oint

sNobody Thought These Would Ever Be Called

Corporate NotesBeyond Credit Analysis: The Make Whole Call (MWC)…Just Be Aware

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* Data as of December 31, 2018** Annualized duration adjusted excess return vs. Treasuries since December 1996 (earliest available excess return data on ABS)

Source: BofA Merrill Lynch & Bloomberg

Sector Index DurationAnnual

Excess Return

BofA ML Auto ABS (AAA) 1.2 Years 0.79%

BofA ML Credit Card ABS (AAA) 1.8 Years 0.83%*

*

**

**

Asset-Backed Securities and Corporate Notes Taking Stock: Actually How Much Do You Get Paid?

BofA ML 1-3 Year Corporate (AAA-A) 1.8 Years 0.73%

BofA ML 1-5 Year Corporate (AAA-A) 2.6 Years 0.69%

*

*

**

**

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* Data as of December 31, 2018** Annualized duration adjusted excess return vs. Treasuries since December 1996 (earliest available excess return data on ABS)

Source: BofA Merrill Lynch & Bloomberg

Sector IndexAnnual

Excess Return

BofA ML Auto ABS (AAA) 0.79%

BofA ML Credit Card ABS (AAA) 0.83%**

**

Asset-Backed Securities and Corporate Notes Taking Stock: Actually How Much Do You Get Paid?

BofA ML 1-3 Year Corporate (AAA-A) 0.73% ** 73% A Rated

100% AAA Rated

100% AAA Rated

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Asset-BackedsAsset-Backed Investors Get Paid Primarily For Managing Cash Flows

Highest Quality Aaa AAA 91%(Smallest Degree of Credit Risk)

High Quality Aa AA 3%(Small Degree of Credit Risk)

Upper Medium Grade A A 3%(Largest Rating Category)

Medium Grade Baa BBB 3%(Neither Well Protected or Speculative)

Moody’s S&P Weight91% Rated

‘AAA’

* Credit weights within the Bloomberg Barclays ABS Index

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Asset-BackedsAsset-Backed Investors Get Paid Primarily For Managing Cash Flows

1 Year Maturity

$ Ca

sh F

low

Time

Treasury / Corporate Bond

1 YearAverage Life

$ Ca

sh F

low

Time

Asset-Backed Security (Auto ABS Example)

Like Treasuries, corporate bonds typically have a

fixed maturity date

Most ABS pay principal & interest over time

and it varies depending on the underlying loans

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• ABS are backed by thousandsof borrowers.

• Credit worthiness is most often independent of the issuer.

• Significant credit support at issuance that builds over time.

• Strong credit profile not reliant on asset valuations.

Generally Speaking:

Asset-BackedsWhat’s Different About an Asset-Backed Security?

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BBB Rated

A Rated

AA Rated

AAARated

Large Value of Auto Loans

Supports Smaller Value of

ABSBonds

Asset-BackedsHow Do Asset-backed Securities Work?

ABS Trust

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Asset-BackedsOverview of ABS Market by Receivables Type: $700 billion Outstanding

Auto Loans31%

Auto Lease11%Credit Card

27%

Other 16%

Equipment 3%

Franchise 5%

Floorplan 8%

Source: SIFMA, Wells Fargo, excludes student loan ABS & CDO/CLO

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Pool of Auto Loans

Placed in ABS Trust

TrustIssues Less

Amount of BondsBacked by Loans

LesserAmount of

AAA Rated Bondsto Total Bonds IssuedAmount of Bonds

Backed by Loans

Overcollateralization

Subordination

Asset-Backeds: How the Typical Auto Structure WorksTwo Types of Credit Support: Overcollateralization & Subordination

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D BBB 29,390,000 3rd Loss Protection 2.0%

Class Rating Size PercentA1

A2-AA2-BA3A4

AAAAAAAAAAAAAAA

297,000,000453,000,00070,000,000

468,000,000104,970,000 93.0%

B AA 42,210,000 5th Loss Protection 2.8%

C A 35,430,000 4th Loss Protection 2.4%

Reserve Account 2nd Loss Protection 0.3%

Excess Spread at Origination 1st Loss Protection 3.6%

11.1%Total Initial Credit Support to Senior Bondholders

Asset-Backeds: How the Typical Auto Structure WorksSubordination Protects The Senior Note Holders 5 Ways

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D BBB 29,390,000 3rd Loss Protection 2.0%

Class Rating Size Percent

A1A2-AA2-BA3A4

AAAAAAAAAAAAAAA

297,000,000453,000,00070,000,000

468,000,000104,970,000 93.0%

B AA 42,210,000 5th Loss Protection 2.8%

C A 35,430,000 4th Loss Protection 2.4%

Reserve Account 2nd Loss Protection 0.3%

Excess Spread at Origination 1st Loss Protection 3.6%

11.1%Total Initial Credit Support to Senior Bonds

0.0

0.5

1.0

1.5

2.0

2001 2003 2005 2007 2009 2011 2013 2015 2017

Prime Auto Loan Net Losses (12-Mo Average)

Source: Wells Fargo

Perc

ent

Asset-Backeds: How the Typical Auto Structure WorksHistorically, Even The Lowest Rated Bonds Have Been Well Protected

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A1 AAA

A2-A FixedA2-B FloatingAAA

A3AAA

A4AAA

B Tranche, AA Rated

C Tranche, A Rated

D Tranche, BBB Rated

Reserve Account and Excess Spread at Origination

AAACredit Support 11.1% 15.9% 24.7% 65.2%

Initial Credit Support to

Senior Bondholders

At Origination

11.1%

Time

Asset-Backeds: How the Typical Auto Structure WorksNatural Deleveraging: The Credit Enhancement Grows As Bonds Pay Down

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Asset-Backeds: How the Typical Auto Structure WorksUnderlying Credit Performance Can Be Monitored Month-to-Month

Type CLC <Go>:• New/Used

• Model Type

• Model Year

• Vehicle Type

• Loan Vintage

• Geographics

NOTE: Bloomberg is not perfect, sometimes you have to go to the servicer reports.

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Asset-Backeds: How the Typical Auto Structure WorksUnderlying Credit Performance Can Be Monitored Month-to-Month

Type CLP <Go>:• # of Loans

• Delinquency Rates

• Cumulative Losses

NOTE: Bloomberg is not perfect, sometimes you have to go to the servicer reports.

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Asset-BackedsThe Unique Advantages of Asset-Backed Securities

Compliments Other Sectors in The Portfolio

Reduce or Eliminate Event Risk Inherent in Single Credit Issues

Credit Stability Through Even the Worst of Market Conditions

Attractive Yields vs. Other Types of Lower Rated Bonds

Achieve Credit and Economic Diversity Within A Single Security

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“Atlanta Capital” AAA-Rated ABS Curve

º

º

º

º

º

º

º

ºº

US Treasury Curve

º

º

ºº

ºº

Asset-Backed Securities and Corporate Notes Valuations Today: Comparing Large & Liquid Issuers in Both Sectors

Note: Data from 3/13/19

Yield Curves Specific Corporate Bond Spreads

2.3%

2.5%

2.7%

2.9%

3.1%

0.25 Years 0.75 Years 1.25 Years 1.75 Years 2.25 Years 2.75 Years

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Asset-Backed Securities and Corporate Notes Taking Stock: A Purely Hypothetical, Back of the Envelope, What If?

$100 Million Portfolio

ABS Allocation Credit Allocation20% @ 50 bps 20% @ 50 bps

Contribution to Excess Return20 bps / year

$200,000 / year$1 Billion Portfolio $2,000,000 / year

These Sectors Have Historically ProducedMeaningful Excess Returns…Worth A Look!

*

**

*See Disclosures!

*

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Thank You!This information is not intended as investment advice or a recommendation to purchase or sell specific securities. These opinions may change atanytime without prior notice, there is no guarantee that any forecasts or opinions expressed in this material will be realized. While every effort hasbeen made to verify the information contained herein, we make no representation as to its accuracy. Company names are used for illustrativepurposes only and should not be construed as a recommendation to buy or sell any financial securities. Index and commodity changes are based onprice-only percentage change. It is not possible to directly invest in an index. Past performance does not predict future results.

This Presentation may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differsignificantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or generaleconomic conditions.

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