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Not a Lot of Upside for Corporate Bonds

Although spreads could grind a bit tighter in the near term, rising interest rates will be a headwind.

David Sekera: The Morningstar Corporate Bond Index rose about 1% in October, predominately due to declining interest rates during the month. Year to date, the index has risen about 6.7%, which has outperformed our expectations that we had initially going into this year.

Now, while we have been correct that corporate credit spreads would trade in a relatively narrow range over the course of the year, where we are incorrect was that we thought interest rates would normalize or rise slightly over the course of the year, whereas they've actually decreased. Thus far this year, the 10-year Treasury, for example, has decreased about 70 basis points and is currently at about 2.3% right now.

There was a brief correction in the stock market earlier in October as the S&P 500 had fallen about 10% on an intraday low off of its highs for the year. However, the stock market quickly rebounded. It is now hitting new highs again. However, when we compare the action in the corporate bond market, there is a little bit of the dislocation.

So, for example, the average spread in the Morningstar Corporate Bond Index right now is 125 basis points. Earlier this year in June, it had gotten as low as 101 basis points. In the high-yield sector, we see similar action in the high-yield universe. So, for example, the Bank of America Merrill Lynch Index was about 335 basis points in June, had risen quite substantially with that correction in October, has rebounded and is now at about 435 basis points.

In the short term, we do expect credit spreads will probably continue to grind tighter over the remainder of the fourth quarter as the economic momentum that we saw in the third quarter carries over into the fourth quarter.

However, for the medium term, we still contend that interest rates should rise and normalize over the next coming 12 to 18 months. As the Fed has exited its asset purchase program and we still expect 2% to 2.5% GDP growth, we really expect interest rates more to go up toward that 3% level on the 10-year as we really just compare what interest rates should be compared to normalized metrics on inflation expectations in the shape of the yield curve.

Thus, we will probably see the tightening credit spreads offset by the rising interest rates, and so therefore, we expect that the investors in high-yield as well as investment-grade will probably earn their carry over the course of the year, but we really don't expect to see further upside from there.