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Credit Insights

Inflation Expectations May Be Heating Up

As commodity prices skyrocket around the world, interest rates have been steadily rising.

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The Morningstar Corporate Bond Index ended last week at a spread of 144 basis points, essentially unchanged from the prior week and 6 basis points tighter since the beginning of the year. We believe credit spreads will tighten further over the course of the year as credit metrics and the economy continue to improve. However, credit selection and covenant protection will be extremely important, as we expect private equity funded leveraged buyouts to increase.

Continued withdrawals from municipal bond funds are causing further dislocations in the municipal bond market. As we highlighted last week, this turmoil is forcing portfolio managers to sell what they can, not what they want to. While the negative headlines have caused an increase in near-term default expectations, we believe the risk is overblown. Tax-exempt municipal bond yields are now trading at or above taxable bond yields for similar credit risks. This has provided an attractive opportunity for investors willing to conduct their own due diligence to pick up extra return on a tax-equivalent basis. Some of the best opportunities exist where the underlying credit risk is a corporate entity that issued debt through a municipal entity that is essentially just a tax-exempt conduit, such as industrial development revenue bonds and pollution control revenue bonds.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.