Credit Spreads Continue to Lag Equity Rally due to Abundance of New Issue Volume
Economic metrics keep Fed on autopilot; ECB intimates more QE is coming.
Following U.S. election results and the European Central Bank's hints that it will expand its monetary policy, the stock market continued to march upward last week. The S&P 500 rose 0.7% and is back to hitting new all-time highs. However, similar to the prior week, credit spreads in the corporate bond market continued to languish by comparison. The average spread of the Morningstar Corporate Bond Index widened 2 basis points and ended the week at +126. In the high-yield sector, the Bank of America Merrill Lynch High Yield Master II Index widened 6 basis points to end the week at +436.
Part of the reason that credit spreads have failed not only to tighten in relation to the rise in equity prices but also to go the other way and widen is the voluminous supply of new issues brought to market last week. As earnings season has come to an end, issuers have exited their quiet periods, and the holidays are rapidly approaching. As such, issuers only have a couple of more weeks to tap the capital markets before the new issue window begins to close. The pace of new issue supply rose substantially last week, and the amount of new issues brought to market was one of the highest weekly amounts priced this year. Investors have been waiting for this supply to come and have held cash in anticipation of putting that cash to work. The sheer volume of new issue supply has been well telegraphed to the market. Portfolio managers have been expecting new issue concessions to widen and presume that they will receive healthy allocations.
Once the pace of new issues begins to slow and trading in the secondary markets decelerates as portfolio managers are able to size up their positions to desired holding levels, we expect credit spreads will grind tighter for the remainder of the year. Even though the Federal Reserve has wound down its asset-purchase program, we expect positive economic momentum will continue through the fourth quarter and forecast GDP growth will be 2.0%-2.5% in 2015. While this growth rate is nothing to write home about, it should be enough to keep default rates near the low single digits in the coming year. In addition, investment-grade and high-yield spread levels have some room to run as both are still well wide of their tights from earlier this year. The tightest level our investment-grade bond index reached earlier this year was +101 on June 24; the tightest the high-yield index reached was +335 on June 23.
Economic Metrics Keep Fed on Autopilot; ECB Intimates More QE Coming
The yield on the 10-year Treasury ended the week at 2.31%, down 3 basis points over the course of the week. Recent economic metrics indicated that the rate of economic growth in the United States has been slowing, but growth continues to be positive. For example, the nonfarm payrolls report showed that jobs increased by 214,000, which was slightly below expectations, but enough to cause the unemployment rate tick down to 5.8%. Both the Manufacturing and Services Purchasing Managers Indexes slowed from the prior month, but at 55.9 and 57.1, both are well above 50, the demarcation between economic expansion and contraction. Similarly, the Institute for Supply Management Non-Manufacturing Report slowed to 57.1; however, the ISM Manufacturing Index beat the trend and rose to 59.0. The takeaway from these metrics is that they were neither strong enough to speed up the date at which the Fed will begin to increase the fed funds rate, nor were they weak enough to keep rates at zero for longer than expected.
The European Central Bank held its policy rates steady following its November meeting, but during the press conference, president Mario Draghi intimated that the ECB is prepared to expand its monetary easing policies if economic growth slows or inflation slips. The ECB began purchasing covered bank bonds last month and will begin purchasing asset-backed bonds later this month. If the liquidity provided by these programs isn't enough to resurrect inflation and stimulate the economy, the ECB may look to begin purchasing corporate bonds as well as sovereign bonds. The wrinkle in purchasing sovereign bonds is that the ECB is prohibited from directly financing governments. However, as we've seen in other developed markets, where there is a will to print money, central bankers will find a way to develop a program to circumnavigate the regulations.
Considering that the ECB reduced its forecasts for GDP growth last week, it appears that this quantitative easing may occur sooner rather than later. The ECB lowered its estimates for GDP growth to 0.8%, 1.1%, and 1.7% for 2014, 2015, and 2016, respectively. Inflation is expected to remain well below the ECB's 2% target at 0.5% in 2014 and 0.8% in 2015. Among the economic metrics, September industrial production in Germany rose only 1.4%, significantly lower than consensus forecasts. While this is an increase from the 3.1% contraction in August, it still points to a slowdown in the country that is the largest economy in the eurozone and has been the stalwart of the region over the past few years.
Second-Largest High-Yield Weekly Inflow in 5 Years
Fund flows into high-yield mutual funds and exchange-traded funds surged to their second-highest weekly inflow in the past five years (the single-largest amount of inflows occurred in October 2011). A total of $3.5 billion flowed into the asset class, and of that, the preponderance of funds was directed into open-end mutual funds. Breaking the flows down even further, on a daily rate, approximately 70% of the weekly inflows occurred on Wednesday, after the election results were released. It appears that the turnover in the Senate spurred the "risk on" trade.