Interest Rates and Bonds

So at long last we know whether the word “patient” stays or goes: it’s gone and Treasury yields have actually declined as a result. So far this year we have seen rates go from a 2015 low of 1.19% on the 5-year and 1.68% on the 10-year on February 2nd, and then spike a month later at 1.70% and 2.24%, respectively, on March 6th. So an over 50bps move in a month all over the worry about the word “patient” and whether rates will rise as early as June. Only for rates to fall after the statement was released and the key word removed.

At the end of the day, does a rate rise in June versus September versus December really matter all that much? We know that the Fed will be increasing the federal funds rate at some point in the future, as it has sat at a historic low of 0-0.25% for the six years since the financial crisis. It has nowhere to go but up. But markets are forward looking mechanisms so will price in expected interest rates moves ahead of actual moves. So as we sit today, has the market already priced in an interest rate move or could we expect a big spike in rates from here?

An ultimate move in the federal funds rate will not be a surprise to anyone and we don’t expect that once the Fed does begin to take action, they’ll move rapidly in raising rates. If recent history has shown us anything, it is that today’s Fed is cautious and seemingly not wanting to surprise or shock markets. There are also a number of headwinds that we expect to temper a strong move in rates, both by the Fed and in Treasury markets in general, including the strong U.S. dollar, inflation below the 2% target, still mixed domestic economic data, and the rate of U.S. government bonds relative to their counterparts throughout the developed world. For instance, looking at the rate of the U.S. 10-year Treasury relative other 10-year government bond rates, it seems hard to make an argument that buyers won’t be there and ultimately temper rates from spiking.1

World bond rates 3-24-15

So while short term rates will move up once the Fed starts to take action, we don’t expect to see a large and rapid increase on rates on the longer-term bonds, such as the 5-year and 10-year.

With all this speculation and concern about rising rates, what does the mean for financial markets once the Fed starts to take action? Specifically for fixed income, investors often seem to be under the notion that anything “bond” related is highly interest rate sensitive and will take a hit if rates rise. However, looking at the 25-year correlation chart below, we see that is far from the truth.2

15 yr correlation as of YE 2014

Certain asset classes, such as investment grade bonds have a high correlation to Treasuries, thus have much more interest rate sensitivity. That means if rates (yields) increase in Treasury bonds, and prices decline, we would theoretically see the same sort of action in investment grade bonds—price declines. However, as noted above, high yield bonds are slightly negatively correlated to Treasuries, so we would expect to theoretically see minimal impact from a move in Treasuries, or even an increase in high yield bond prices.

Looking at the actual returns for the high yield asset class, in the 15 calendar year periods since 1980 where we saw Treasury yields increase, high yield bonds posted an average return of 13.7% over those annual periods.3 A few other things to keep in mind, high yield bonds have historically been much more linked to credit quality than interest rates. We would expect to see rates rise during stable to improving economic conditions, which we would expect to be favorable to business fundamentals and credit metrics, and thus to high yield investors.

While we don’t expect a rapid increase in rates, if rates do rise, high yield bonds have a good historical track record in this type of environment. Given the low to negative Treasury correlations versus other asset classes, an allocation to high yield bonds may serve to improve a portfolio’s diversification and potentially even lower risk depending on the mix of assets.

1 Data sourced from Bloomberg as of March 24, 2015.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. A153.
3 Data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113. “High-Yield Market Monitor,” J.P. Morgan, January 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013, and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website.

 

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Upcoming TV Appearance

Tim Gramatovich, Peritus’ Chief Investment Officer, will be a guest on CNBC’s “Closing Bell” on Wednesday, March 25th at 3pm ET.

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The State of Global Energy Markets

Blog 3-9-15

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The High Yield Default Outlook

We see default risk as the most prominent risk for credit investors.  As we look forward, a benign default environment is projected over the next few years.1

Blog 3-3-15 Default rate

Broadly speaking, this projection does make sense to us.  Some of the triggers for default include an inability to continue servicing debt by paying the semi-annual interest on the bonds, as well as an inability to repay or refinance the bonds upon maturity.  As J.P. Morgan recently noted2:

Combined, high-yield bond and loan issuance totaled $1.9trn over the last two years, with the emphasis of this on refinancing. As a result, maturities between now and 2017 remain low and are lower than where they stood several years ago. As it stands, only $31bn of high-yield bonds and loans come due between now and yearend, while only $85bn in debt comes due in 2016, making the total amount of debt set to mature in the next two years a mere $116bn, an amount equal to roughly four-and-a-half months refinancing volume based on last year’s run rate. Further, over the next two and three years a mere 4.5% and 10.9% of the $2.6trn leveraged credit market will mature. By comparison, at year end 2010, 10.1% and 21.2% of the market was coming due in two and three years, double today’s levels.

The low interest rate environment and wide open refinancing market have allowed companies to push out their maturities and add liquidity to their balance sheets, positioning them well for the years ahead.  And as noted, this new issuance activity has largely been for refinancings, not massive acquisitions or LBOs, indicating that companies are not levering up their balance sheets as we have seen in past cycles.3

Blog 3-3-15b

Looking at the default outlook another way, as we begin 2015, the projected default rates are well below what the spread level would imply as the future default rate:4

Blog 3-3-15c

So based on spread levels, we are looking at an implied default rate of about 4.3%, right near the historical averages.  But over the next couple years, the projected default rates are expected to be about half of that.  Given the high yield market is generating a spread level around historical averages, yet default rates are projected to be well below average, we believe this translates to attractive value in today’s markets.  However, investors must make sure that they still understand what they own and the prospects for their individual holdings.  A benign default environment is a definite positive, but it must not lead to investor complacency.

We believe the broader high yield market is positioned well for the years ahead, but that outlook has been dramatically altered for the energy sector given the huge fall in oil prices that we have seen.  The energy market makes up about 17% of the high yield index5 and this industry has been strong issuer over the past couple years.  While we certainly do see value in certain energy production and services companies that will be survivors at current oil prices, we believe that others are poised for a very rough road ahead.  Projections are for the default rates within the energy sector to massively spike once oil hits $65 or below on a sustained basis (currently, we are right about $50/barrel).6

Blog 3-3-15d

We see those most at risk are domestic shale producers, which have been bond issuers as they have tapped markets for capital to sustain their production.  As we have noted in our prior writings (see our piece, “The Year Ahead: High Yield, Energy, and Interest Rates”), many U.S. shale producers weren’t generating cash flow even with oil at $100 and face rapid well decline rates, requiring heavy capital reinvestment to sustain production.7  So as we sit today, the cash flow usage situation has gotten much worse with oil prices cut in half and the access to new capital has significantly dried up, so those companies needing new capital to sustain production may likely be out of luck.  We believe this may well lead to a downward spiral of production dramatically falling off and cash not being there to service the existing debt load, thus defaults may occur for many involved.

Again, we don’t want to paint the energy sector as all the same—there is what we see as attractive value at current price points in certain credits, as bond and loan pricing has been taken down in some cases as an over-reaction, but there are also value traps of which investors must beware.  Investors need to be actively doing the credit work to determine the individual company’s liquidity, their cash needs to continue production, and stress test the companies under current oil prices.  Investors need to further assess where in the capital structure it is best to be positioned.

Investors are searching for yield, and we believe there is attractive yield to be had in the high yield market, especially considering the benign default outlook for the vast majority of the market.  But we are ardent believers that investing in the high yield market does take active credit selection and thorough fundamental analysis, rather than just modeling an index without attention paid to the viability of the credit or where in the capital structure to be positioned.

1 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 115.
2 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. February 20, 2015, p. 1.
3 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 28.
4 Spread to worst level as of February 5, 2015. Other data from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li, “Credit Strategy Weekly Update,” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 16, 2015, p. 6. As determined by J.P. Morgan: Excess spread equals the monthly median of the difference between actual spreads and default loss during the last 25 years for bonds. Excess spread tends to rise and fall with shifts in the default cycle, as higher defaults eventually meet “reflective” spreads, causing a compression in excess levels. We like to think of excess spreads as the premium an investor requires to be paid above the expected default loss.
5 Energy is 17% of the JP Morgan USD US High Yield Index. Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 7.
6 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 54.
7 See our piece, “The Year Ahead: High Yield, Energy, and Interest Rates,” information on well decline rates on p. 14.
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Today’s Floating Rate Loan Market

Together the high yield bond and floating rate bank loan market total over $3 trillion.1 This has evolved into a significant, and growing asset class. With high yield bonds and loans now representing about 30% of corporate credit2, this market deserves not only our attention, but we also feel is ripe with opportunity for investors.

We recently have written on the current opportunity in the high yield bond market (see our commentaries, “The Opportunity in Volatility” and “Alpha Generation for Active Managers”), but now let’s turn our attention to the opportunity set we see in floating rate bank loans. Many often see this market as a duration play—a way to invest if you think rates will rise. Yes, loans benefit from the “floating” rate via the generally quarterly LIBOR-based interest rate reset. However, investors need to keep in mind that a large portion of these loans have LIBOR floors, often ranging from 1-1.5%. This means that we would need to see LIBOR move 0.75-1.25% off of current levels to move the rate realized by the investor. As a frame of reference, we’ve barely seen 3 month LIBOR move over the last few years.3

Blog 2-25-15a

So not only do you need to see a pretty significant move in interest rates to surpass that floor, and we don’t expect the Fed to take aggressive action by rapidly and sizably raising rates, but you would need to also see interest rate moves here at home impact LIBOR (the London Interbank Offered Rate), despite the quantitative easing we are seeing elsewhere in the world.

While there is certainly a duration benefit to a portfolio by investing in floating rate loans, we believe that investors embracing the loan market as a pure interest rate/duration play may well be disappointed. The more significant value that we see in this market is the expansive number of issuers and issues this market encompasses, allowing investors’ access to companies that may not issue high yield bonds and/or to secured securities in a company’s capital structure, expanding the opportunity set for yield-seeking investors.

As we ended 2013 and entered 2014, the clear consensus was that interest rates were rising and with that, investors poured money into the loan asset class. From mid-2012 to April of 2014 we saw a record 95 total weeks of consecutive mutual and exchange traded fund inflows into the floating rate loan asset class, totaling $81 billion.4 During that period, loan prices ran up and yields became compressed. As that higher rate expectation clearly didn’t play out as 2014 progressed, we saw a sharp reversal in the interest in the loan market. Since the spring of 2014 through mid-February we saw 42 of the last 44 weeks post fund outflows, for a total of $35 billion over this period.5

As we have seen investors leave this asset class, we have seen loan prices fall and yields increase. For instance we began 2014 with 84% of loans trading at a premium to par ($100). Yet we entered 2015 with only 19% of loans at a premium.6 We have seen a clear spread and yield widening in this asset class, which we view as an attractive opportunity for active investors that can look for those loans that offer the best value relative to risk. Keep in mind that loans are secured securities that are at the top of a company’s capital structure, ahead of unsecured bonds and equities, adding another potential layer of risk reduction for investors.

With what we see as attractive yields and discounts creating the potential for capital gains in many cases, today we see compelling value in both the high yield bond and floating rate bank loan markets for investors who have the flexibility to not only invest in both markets but also look for what they see as the best value within each market. Again, the high yield bond and floating rate bank loan markets are large and growing, and that along with the current opportunity we see in them warrants yield-seeking investors’ attention.

1 High yield bonds market size from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research, January 9, 2015, p. 40. Loan market size from Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Monthly,” Fixed Income Research, January 6, 2015.
2 Source SIFMA as of 9/30/2014 for total corporate debt.
3 3-month LIBOR, data sourced from Bloomberg.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leveraged Loan Market Monitor.” J.P. Morgan, North American High Yield and Leveraged Loan Research. January 5, 2015, p. 7.
5 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research. February 13, 2015, p. 9.
6 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2014 High-Yield Annual Review.” J.P. Morgan, North American High Yield and Leveraged Loan Research. December 29, 2014, p. 26.
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Peritus in the News

Peritus was mentioned in the article “ETF Chart of the Day: Return to Junk” by Paul Weisbruch of Street One Financial, on February 19, 2015.

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High Yield in a Rising Rate Environment: Duration and Yield

We began February with a yield on the 10-year Treasury of 1.68% and today sit at 2.14%.1 All the concerns and talk of maybe even no rate rise this year that we saw in January, have turned to frequent mention of a rate rise beginning in June. So what are bond investors to do? Is this finally the year of rising rates and what impact does that have?

Yes, it is well understood that the Federal Reserve will be raising the federal funds rate off of the 0.0-0.25% target that we have seen since the financial crisis. The timing is anyone’s guess, but at the end of the day markets are forward looking mechanisms and have/will price this move in long before it actually happens. Even if the Fed does start to raise rates this year, we don’t expect them to do so rapidly and we don’t expect their actions to have a dramatic impact on the 5- and 10-year Treasuries.

That being said, one thing we know over the last year is that interest rate moves have surprised nearly everyone. But what about investors that are concerned rates will make a sizable move up and with that, how various fixed income asset classes will perform in this environment? Let’s take a look at some data points.

One primary way to evaluate interest rate sensitivity is with duration, a measure of the price change of a fixed-income security in response to a change in interest rates. Per this calculation, rates and prices move in the opposite direction, so an increase in rates would produce a decline in price. Below are the durations and yields for various fixed income asset classes.2

Blog 2-17-15a

As you can see in the chart above, municipal bonds and the 5-year Treasury carry a duration near 5 years, investment grade bonds have a duration of over 7 years, and high yield bonds offer the lowest duration of just about 4 years, meaning the high yield asset class carries the lowest sensitivity to interest rates. In other words, all else equal, a given increase in interest rates will move the price of investment grade bonds down significantly more than high yield bonds.

The number of years to maturity for the asset is one factor in determining duration, but the starting yield also plays an important role. After a big run in 2014, municipals now offer a yield to worst only slightly over that generated by the 5-year Treasury, both under 2%. The yield to worst on the investment grade index is about 3%, while the broader high yield index offers a yield to worst of twice that, over 6%. So not only do high yield bonds offer the lowest duration, they also offer the highest yield. So how does that play into a rising rate environment? Well, it means that high yield bonds are much less interest rate sensitive than these other fixed income alternatives. And while the traditional adage in fixed income is that as interest rates go up, prices on bonds go down, that doesn’t factor in the yield being received which may outweigh the price decline, all else equal. So investors need to consider both yield and duration.

Looking back through history when we have seen rates rise, we have certainly not seen weak returns in the high yield market. For instance, in the 15 years that we have seen Treasury yield increases (rates rise) since 1980, the high yield bond market has posted an average return of 13.7% (or 10.4% if you exclude the massive performance in 2009). This compares to an average return of 4.5% (or 3.6% if you exclude 2009) for investment grade bonds over the same period.3

Blog 2-17-15b

Intuitively this makes sense because generally rates rise during periods of economic strength, and a strong economy is generally favorable for corporate credit. Historically we have seen the prices of high yield bonds much more linked to credit quality than to interest rates.

For all the chatter that bonds will get hit as rates rise and it is time to move to equities, this historical data would indicate that high yield bonds have certainly not suffered as rates rose in the past. While we currently have our concerns about longer duration asset classes, such as investment grade and municipal bonds, we believe that high yield bonds are positioned well for the rate uncertainty ahead. If rates don’t move much for the year, then you have a much higher starting yield for high yield bonds, and if rates do increase, the high yield asset class has a much lower duration.   Furthermore, also including floating rate bank loans in your portfolio can serve to further reduce your duration.

Right now we see many attractive opportunities for investments for active managers in the high yield bond and loan space. There remain over-valued credits and vulnerable credits (such as certain sub-sectors of the energy space) that we would recommend avoiding, but in the mix are also many bonds and loans that offer value for active managers who can select the securities they feel are positioned well for the environment ahead.

1 5-year Treasury rates as of 2/2/15 and 2/17/15.
2 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt (source Barclays Capital). U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital). Barclays data as of 2/13/15 and Treasury data as of 2/17/15. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is based on the yield to worst date, using Macaulay duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.
3 Data sourced from: Acciavatti, Peter Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “2008 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 2008, p. 113. “High-Yield Market Monitor,” J.P. Morgan, January 5, 2009, January 5, 2010, January 3, 2011, January 3, 2012, January 2, 2013, and January 2, 2014. 2008-2012 Treasury data sourced from Bloomberg (US Generic Govt 5 Yr), 2013 data from the Federal Reserve website. The J.P. Morgan High Yield bond index is designed to mirror the investible universe of US dollar high-yield corporate debt market, including domestic and international issues. The J.P. Morgan Investment Grade Corporate bond index represents the investment grade US dollar denominated corporate bond market, focusing on bullet maturities paying a non-zero coupon.
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Peritus in the News

Peritus was mentioned in the article “Potential Opportunities in Junk, High Yield Bond ETFs” by Max Chen of ETF Trends, February 17, 2015.

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Alpha Generation for Active Managers

As we discussed in our recent blog (see “The Opportunity in Volatility”), we are currently seeing a lot of attractive opportunities in the high yield market—discounts and yields that we haven’t seen in some time.  And while we have seen the yields in the high yield indexes and the products that track them increase over the last six months, they don’t really seem to reflect the true opportunity we are seeing in the market.    For instance, the yield to worst on the Barclays High Yield index is 6.46%1 and many of the large index-based products are reporting yields around 6%.  While this is certainly better than the index yields of sub-5% that we saw in mid-2014, this level at face value isn’t something we’d be really excited about.  So then why are we excited about today’s high yield market and see this as an attractive entry point?

Digging into what is held in the index, we see 33% of the issuers in index trade at a yield-to-worst of 5% or under.2  The large majority of this low-yielding contingency consists of quasi-investment grade bonds, rated Ba1 to Ba3.  Not only does this group provide a low starting yield, but would expose investors to more interest rate sensitivity if and when we do eventually see rates rise (given the lower starting yields).

On the flip side, 30% of the issuers in that index are trading at a yield-to-worst of 7.5% and above2, which in today’s low yielding environment, with the 5-year Treasury around 1.2%, seems pretty decent.   This group is certainly not dominated by the lowest rated of names and within this group, we are seeing an eclectic mix of businesses and industries.  Yes, there are segments of this group that we are not interested in.  For instance, we have been outspoken on our concerns for many of the domestic shale producers in the energy space given that we saw these as unsustainable business models when oil was near $100, and those issues will certainly be acerbated with oil at $50 as cash to mitigate the rapid well decline rates and to service heavy debt loads quickly runs out (see our writings “Intentional About Energy” or “Rome is Burning”).  But there are also what we see as great mix of business and industries that we would be interested in committing money to, especially at these levels.

This is where active management is especially important.  We view active management as about managing risk and finding value.  Yes, it is about managing credit risk (determining the underlying credit fundamentals and prospects of each investment you make—basically doing the fundamental analysis to justify an investment in a given security) and managing call risk (paying attention to the price you are paying for a security relative to the next call price to address the issue of negative convexity), as we have written about at length before (see our pieces “Peritus’ Investor’s Manual”).  Yet one risk factor that is often overlooked is that of purchase price.

By this we mean buying at an attractive price.  While it isn’t very intuitive, because it often seems that the risk is less when markets are on a roll and moving up, but really the lower the price you pay for a security, the lower the risk (you have less to lose because you put less in up front).  Jumping in on the popular trade certainly doesn’t reduce your risk profile.  Rather, you want to purchase a security for a price less than you think it is worth.

As we look at much of the secondary high yield market, especially many of the B and CCC names that have been out of favor over the past several months, we are seeing a more attractive buy-in for selective, active managers, which we believe lowers our risk.  And there remains a segment of “high yield” that isn’t at prices or yields that we would consider attractive, and we will avoid investments in those securities.  Alpha generation involves buying what we see as undervalued securities with the goal of generating excess yield and/or potential capital gains.  Today, we are seeing this opportunity for potential alpha generation for active managers.

1 Barclays Capital US High Yield Index yield to worst as of 1/30/15. Formerly the Lehman Brothers US High Yield Index, this is an unmanaged index considered representative of the universe of US fixed rate, non-investment grade debt.
2 Based on our analysis of the Barclays Capital High Yield index constituents as of 1/30/15.
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Peritus in the News

Peritus was mentioned in the article “Junk Bond ETFs Try to Shake Off Energy Pullback,” by Tom Lydon of ETF Trends, February 6, 2015.

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