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CopperPoint Mutual Insurance Company
Phone: (602) 631-2000
Address: 3030 North Third Street
Phoenix, AZ   85012
Website: www.copperpoint.com

State Compensation Insurance Fund
Phone: 888-STATEFUNDCA
Address: 333 Bush Street
Suite 800
San Francisco, CA   94104
Website: www.statefundca.com

Pinnacol Assurance
Phone: (303) 361-4000
Address: 7501 East Lowry Boulevard
Suite 800
Denver, CO   80230-7006
Website: www.pinnacol.com

Hawaii Employers' Mutual Insurance Co. Inc.
Phone: (808) 524-3642
Address: 1100 Alakea Street
Suite 1400
Honolulu, HI   96813
Website: www.hemic.com

Idaho State Insurance Fund
Phone: (208) 332-2100
Address: 1215 West State Street
P.O. Box 83720
Boise, ID   83720-0044
Website: www.idahosif.org

Kentucky Employers Mutual Insurance
Phone: (859) 425-7800
Address: 250 West Main Street Suite 900
P.O. Box 83720
Lexington, KY   40507-1724
Website: www.kemi.com

Louisiana Workers' Compensation Corporation
Phone: (225) 924-7788
Address: 2237 South Acadian Thruway
P.O. Box 83720
Baton Rouge, LA   70808
Website: www.lwcc.com

Maine Employers Mutual Insurance Company (MEMIC)
Phone: (207) 791-3300
Address: 261 Commercial Street
P.O. Box 11409
Portland, ME   04104
Website: www.memic.com

Chesapeake Employers’ Insurance Company
Phone: (410) 494-2000
Address: 8722 Loch Raven Boulevard
P.O. Box 11409
Towson, MD   21286-2235
Website: www.ceiwc.com

SFM Mutual Insurance Company
Phone: (952) 838-4200
Address: 3500 American Boulevard West Suite 700
P.O. Box 11409
Bloomington, MN   55431-4434
Website: www.sfmic.com

Missouri Employers Mutual Insurance
Phone: (800) 442-0590
Address: 101 N Keene St
P.O. Box 11409
Columbia, MO   65201
Website: www.mem-ins.com

Montana State Fund
Phone: (406) 495-5015
Address: 855 Front Street
P.O. Box 4759
Helena, MT   59604-4759
Website: www.montanastatefund.com

New Mexico Mutual Group
Phone: (505) 345-7260
Address: 3900 Singer Boulevard NE
P.O. Box 4759
Albuquerque, NM   87109
Website: www.newmexicomutual.com

New York State Insurance Fund
Phone: (212) 312-7001
Address: 199 Church Street
P.O. Box 4759
New York, NY   10007
Website: www.nysif.com

Workforce Safety and Insurance
Phone: (701) 328-3800
Address: 1600 East Century Avenue Suite 1
P.O. Box 4759
Bismarck, ND   58506-5585
Website: www.WorkforceSafety.com

Ohio Bureau of Workers Compensation
Phone: (800) 644-6292
Address: 30 West Spring Street
P.O. Box 4759
Columbus, OH   43215-2256
Website: www.bwc.ohio.gov

CompSource Mutual Insurance Company
Phone: (405) 232-7663
Address: 1901 North Walnut Ave.
P.O. Box 53505
Oklahoma City, OK   73152-3505
Website: www.compsourcemutual.com

State Accident Insurance Fund (SAIF)
Phone: (503) 373-8000
Address: 400 High Street SE
P.O. Box 53505
Salem, OR   97312-1000
Website: www.saif.com

Pennsylvania State Workers Insurance Fund
Phone: (570) 963-4635
Address: 100 Lackawanna Avenue
P.O. Box 5100
Scranton, PA   18505-5100
Website: www.dli.state.pa.us/swif

Beacon Mutual Insurance Company
Phone: (401) 825-2667
Address: One Beacon Centre
P.O. Box 5100
Warwick, RI   02886-1378
Website: www.beaconmutual.com

South Carolina State Accident Fund
Phone: (803) 896-5800
Address: P.O. Box 102100
P.O. Box 5100
Columbia, SC   29221-5000
Website: www.saf.sc.gov

Texas Mutual Insurance Company
Phone: (800) 859-5995
Address: 6210 East Highway 290
P.O. Box 5100
Austin, TX   78723-1098
Website: www.texasmutual.com

Workers Compensation Fund
Phone: (800) 446-2667
Address: 100 West Towne Ridge Parkway
P.O. Box 2227
Sandy, UT   84070
Website: www.wcfgroup.com

Washington Department of Labor and Industries
Phone: (360) 902-5800
Address: P.O. Box 44001
P.O. Box 2227
Olympia, WA   98504-4001
Website: www.lni.wa.gov

Wyoming Division of Workers Safety & Compensation
Phone: (307) 777-7159
Address: Cheyenne Business Center
1510 East Pershing Boulevard
Cheyenne, WY   82002
Website: wydoe.state.wy.us

Workers Compensation Board - Alberta
Phone: (780) 498-3999
Address: 9925-107 Street
P.O. Box 2415
Edmonton, AB   T5J 2S5
Website: www.wcb.ab.ca

Workers Compensation Board of British Columbia (WORKSAFEBC)
Phone: (604) 273-2266
Address: P.O. Box 5350 Station Terminal
P.O. Box 2415
Vancouver, BC   V6B 5L5
Website: www.worksafebc.com

Manitoba Workers Compensation Board
Phone: (204) 954-4321
Address: 333 Broadway
P.O. Box 2415
Winnipeg, MB   R3C 4W3
Website: www.wcb.mb.ca

WorkSafeNB
Phone: (506) 632-2200
Address: 1 Portland Street
P.O. Box 160
Saint John, NB   E2L 3X9
Website: www.worksafenb.ca

Workers Compensation Board of Nova Scotia
Phone: (902) 491-8999
Address: 5668 South Street
P.O. Box 1150
Halifax, NS   B3J 2Y2
Website: www.wcb.ns.ca

Prince Edward Island Workers Compensation Board
Phone: (902) 368-5680
Address: 14 Weymouth Street
P.O. Box 1150
Charlottetown, PE   C1A 7L7
Website: www.wcb.pe.ca

Saskatchewan Workers Compensation Board
Phone: (306) 787-4370
Address: 200 - 1881 Scarth Street
P.O. Box 1150
Regina, SK   S4P 4L1
Website: www.wcbsask.com

Puerto Rico State Insurance Fund Corporation
Phone: (787) 793-5959
Address: G.P.O. Box 365028
P.O. Box 1150
San Juan, PR   00936-5028
Website: www.cfse.gov.pr
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Keeping Diversification in Mind in the Core Market for 2019

Contributed by DWS's Greg Staples—Co-head of Fixed Income, N. America; Scott Agi—Sector Head, MBS & Rates; Thomas Sweeney—Sector Head, Structured Finance

DWS is the sponsor of AASCIF's Finance and Investment Track.

The Fed’s tightening and QE unwind, volatility in the investment-grade credit and high-yield sectors, and a lengthening credit cycle made 2018 a challenging year for bonds. However, there are potential options in higher quality areas where we see diversification possibilities in MBS, ABS, and CLOs.

Executive Overview

  • The Federal Reserve’s tightening, its continued unwinding of its quantitative easing (QE) portfolio, increased volatility in investment-grade and high-yield sectors, and concerns over a possible end to accommodative credit conditions made 2018 a challenging year for the bond markets.

  • Despite cheapening valuations in credit, volatility may be resurfacing as the economic cycle shifts into its later stages. We believe diversification strategies incorporating mortgage-backed securities (MBS) and Structured Finance sectors should continue to be attractive in light of the market’s challenges.

  • Agency MBS look fairly attractive, both in terms of nominal spreads and the reduction in prepayment risk given the year-end index price of $100.86.

  • In Structured Finance, we are looking at traditional asset-backed securities (ABS) and high-quality collateralized loan obligation (CLO) markets, with caution in such segments as Non-Agency CMBS.
A Transitional Year
Several important factors made 2018 a transitional year for the bond markets. The Federal Reserve’s (Fed’s) gradual tightening and concerns about economic growth widened spreads in the investment-grade and high-yield bond markets. It also led to a bear flattening in the Treasury yield curve, with short-term rates rising +120 basis points and long-term rates rising only +28 basis points (comparing 1-month bills versus 30yr UST rates). Meanwhile, the Fed’s ongoing reduction of Its quantitative easing portfolio has affected conditions in the MBS market. Neither of these Fed moves were unexpected or abrupt, but they have caused an ongoing repricing of what the market considers “normal.”

After a bull run that began nearly 35 years ago, these and other factors indicate that the bond market could be poised to turn bearish. Its underperformance can be seen in the 2018 returns for the Bloomberg Barclays U.S. Aggregate Bond Index, which ended the year flat but was plagued by negative excess returns across most spread sectors. Admittedly, some of this was due to “tape bombs”—the uptick in retailer bankruptcies, China trade sabre rattling, FAANG tech stock retrenchment, oil volatility, and so on.



This leaves us with a number of questions regarding portfolio strategies in 2019. Will the Fed continue to tighten and if so, how will this and supply and demand dynamics impact the overall yield curve? For risk investors engaged in the credit market, is the cycle nearing its end? Is it time to perhaps engage in other higher-quality markets, such as MBS and Structured Finance? This report will examine these issues and delve into how these factors might drive liquidity conditions and correlations in a higher volatility market environment.

The Outlook for MBS
Our view on rates in 2019 is fairly benign. However, we are dealing with a market that, generally speaking, is starting to reprice against a risk-free rate that is much more attractive than it has been for the last 10 years, when comparing the Fed Fund Rate to shorter-dated bond instruments. That means some sectors within Structured Finance, and even within Treasuries and rates products, are again becoming attractive from a return perspective.

In the Agency MBS market we have been somewhat cautious over the past 12 months, with the expectation that spreads could widen as a result of the Fed tapering program, volatility picking up, and rates selling off. Throughout 2018 we experienced 17 basis points of option-adjusted spread movement from peak to trough, but nominal spreads have undergone a larger impact. With a range of +35 basis points over the 12-month period, the MBS current coupon spread closed the year near multi-year wides at 91 basis points over Treasuries. (See Figure 2.)

Agency MBS is typically viewed as a relatively stable asset class that has historically outperformed competing spread sectors in periods of elevated volatility when comparing Sharpe Ratios in the years following the Financial Crisis. That is useful now since Fed tightening, potential curve inversion, geopolitical risks, tariff headlines, and regulatory constraints in capital markets all point to a heightened risk of renewed volatility in the next cycle.

Agency MBS looks fairly attractive, both from a nominal perspective and from a relative value perspective when incorporating some measure of spread volatility. While corporate bonds generally trade at wider spreads than Agency MBS, the volatility of excess returns increased in 2018 (DWS CIO Office, December 2018), thus driving Sharpe Ratios lower as a result.  With yields improving into higher rates and investors looking to diversify under the late cycle economic backdrop, our view is that demand for MBS has been accelerating based on these market actions. This should help absorb the supply associated with the tapering of the Fed’s balance sheet, and limit spread widening.

Also, higher rates have led to slower prepayment speeds as mortgage refinancings fall. Thus there is now less optionality in Agency MBS. The Bloomberg Barclays MBS Index, using analytics from BlackRock Aladdin Solutions, traded at $100.86 at year-end, with a 3.38 percent yield-to-worst and a weighted average prepayment speed of 6.6 CPR.

Although we find Agency MBS attractive, there are some headwinds in the future, mostly related to net supply. Our outlook for 2019 assumes another $400 billion to $450 billion in net supply, including approximately $180 billion from the FOMC balance sheet runoff. We need to ascertain what institutions will replace the Fed as the backstop for the mortgage market. The market expects foreign investors or domestic banks to fill the gap, but neither group would appear to be hard-pressed to buy until they see better valuations or lower volatility, based on our analysis.

In general, even if a renewed period of volatility in 2019 and wider spreads are expected, we are forecasting Agency MBS total returns to remain positive and think that MBS will hold up better than most other spread sectors from a volatility perspective.



Figure 3 illustrates both the size of the MBS market and some of its benefits. This is a $6 trillion market that still has very good liquidity and provides the same type of yield and duration exposure available in other credit instruments.

Given the liquidity and lack of optionality in MBS, it can be a good place to look for relative value. We believe there is still yield to be had in some of the lower credit segments of the corporate market, but when looking for higher-quality, higher-rated investments, MBS warrants some attention.

Furthermore, we also believe that new issues are not structured as attractively as legacy issues. Aside from relatively tight spread levels (compared to MBS pass-throughs), Collateralized Mortgage Obligation (CMO) structures are being created off of generic and/or jumbo collateral with poor convexity profiles that embed more extension risk, and provide less prepayment protection than they provided historically. We would believe it is preferable to hold legacy issues and explore secondary CMOs as a defensive play, rather than purchasing new issues.

At fourth-quarter 2018 spread levels, pass-throughs were favorable as convexity improved into higher rates. On the range of mortgage coupons (coupon stack), there are more opportunities to capture alpha from prepayment expectations in coupons that are further away from par. Conversely, we view locking in yields for dollar par securities (as seen in Figure 4) as potentially attractive in longer duration strategies because of the ability to secure a 3.5% yield.

Figure 4: DWS Perspectives on Major MBS Themes

Agency MBS

Positives: Fundamentally, at the wider end of the range in both nominal and option-adjusted spread. Attractive risk/reward versus competing high quality spread sectors when incorporating recent spread volatility.
Negatives:
Net supply expected to tick higher with the Fed no longer reinvesting paydowns. Money managers increased MBS allocation earlier this year, but may rotate back into credit as spreads have widened.

Constructive toward well-structured legacy cash-flows in CMOs as new issues are “wolves in sheep’s clothing”

Nominal spreads are tight, but superior convexity may protect against duration drifts and prepayment risk.

Value in long duration discount priced CMOs with locked out cash flows and positive convexity.

Agency CMBS in the “belly of the curve” warrants attention since bullet cash flow can provide payment certainty and roll-down.

Seasoned loan balance collateral in discount dollar priced pass-throughs to protect against both faster prepayments and duration extension. We would avoid high pay-up collateral in premium sectors in favor of lower payup collateral with favorable borrower characteristics that we think can improve convexity and OAS at marginal cost.

Source: DWS, December 2018.
Forecasts are based on assumptions, estimates, opinions, and hypothetical models or analysis which may prove to be incorrect.

The Outlook for Structured Finance
In 2018, Structured Finance performance was bifurcated into a modestly positive first three quarters of the year and then a very weak final quarter. Sector performance suffered from both heavy issuance—a post-crisis record of $650 billion (DWS data using Bloomberg)—and investor rotation out of spread product during the fourth quarter. Given the sector’s bias toward AAA assets, Structured Finance unsurprisingly outperformed lower-rated spread sectors like corporates and high-yield while underperforming lower beta sectors. Credit conditions in the sector were strong, helped by low unemployment and strong consumer balance sheets. Against that backdrop, higher-quality, fixed-rate assets could be more attractive versus down-in-credit, floating-rate assets. We are forecasting credit conditions to remain benign, however, some retracement from recent low levels can be expected.

ABS
ABS was the only sector in the Bloomberg Barclays U.S. Aggregate Bond Index to have positive excess returns, when compared to equivalent duration Treasuries, in 2018. The sector outperformed other spread sectors due to its higher quality bias (mostly AAA rated), and relatively low duration compared to other spread sectors. Overall, supply has been at a record pace in 2018 totaling $232 billion (DWS data using Bloomberg). Going into 2019, we expect supply to slow slightly as higher rates lower consumer demand for loans, particularly in autos; expect more esoteric assets classes to test the market if demand continues. Credit performance has been strong over the last cycle and we expect conditions to remain relatively benign, with some deterioration in deep subprime and consumer loans. In this environment, we believe fixed-rate traditional ABS, including autos and cards for example, to be more interesting as short defensive sectors with attractive yields.


CMBS
CMBS, like other risk assets, underperformed significantly during the large risk-off move in the fourth quarter. Excess returns for the quarter were -105 basis points and the sector finished the year with excess returns of -47 basis points  when compared to equivalent duration Treasuries. Traditional conduit deal supply continues to disappoint with total issuance of $41 billion in 2018, well off from the 2007 high of $188 billion (DWS data using Bloomberg). In addition, non-traditional sectors like Single Asset Single Borrower (SASB) and CRE CLOs continue to grow at the expense of traditional conduit CMBS. We expect the rise in interest rates to slow CRE appreciation and retail to continue to be challenged by secular changes in that sector. Long Agency CMBS exhibits some positive characteristics as a defensive sector that could outperform in a selloff and intermediate 3-7 year AAA Non-agency CMBS has the potential for yield improvement.

CLOs
CLOs underperformed significantly in the fourth-quarter both from the risk-off move and the demand shift from floating rate to fixed rate assets. The credit curve steepened significantly over the quarter, with AAAs and AAs outperforming while BBs and below underperformed. Further pressuring spreads, the market saw record new supply at $127 billion. The sector delivered a solid total return of 1.27%, outperforming CMBS (+0.78%), but slightly underperforming ABS (+1.77%), all based on respective Bloomberg Barclays index returns. This year, we favor up-in-quality bias given the deterioration quality of the underlying loans and potential for demand to decrease for floating rate assets.

Conclusion
The credit and fixed income markets could recover and continue to power along in 2019, leaving 2018 looking like an aberration and not a precursor to a more difficult environment. This is not to say there aren’t sectors across the bond market that can be examined for yield or risk-adjusted return opportunities. We believe, however, it is prudent to plan for a more volatile and complex market this year and examine opportunities that might exist across the various sectors of the Core fixed income market.

Contributors
Greg Staples—Co-head of Fixed Income, N. America
Scott Agi—Sector Head, MBS & Rates
Thomas Sweeney—Sector Head, Structured Finance
January 2019

 

DWS is the sponsor of AASCIF's Finance and Investment Track.
The views expressed represent those of the sponsor, not necessarily of AASCIF and its member companies.


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The material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It is for professional investors only. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein.

Please note that this information is not intended to provide tax or legal advice and should not be relied upon as such. DWS does not provide tax, legal or accounting advice. Please consult with your respective experts before making investment decisions.

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This document is intended for discussion purposes only and does not create any legally binding obligations on the part of DWS and/or its affiliates. Without limitation, this document does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for DWS to enter into or arrange any type of transaction as a consequence of any information contained herein. The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Past performance is not a guarantee of future results. Any forecasts provided herein are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to risks, including possible loss of principal amount invested.

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The material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It is for professional investors only. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for DWS and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Investment decisions should always be based on the Sales Prospectus, supplemented in each case by the most recent audited annual report and, in addition, by the most recent half-year report, if this report is more recent than the most recently available annual report. Past performance is not indicative of future results. No representation or warranty is made as to the efficacy of any particular strategy or the actual returns that may be achieved.

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