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Credit Insights

Robust Liquidity Returns to Corporate Bond Market

New issue market reaches new volume records

Following the Thanksgiving holiday, robust two-way flows returned as the buyers who had been missing from the marketplace showed up. Liquidity improved significantly across the market, although one trader noted that it was still difficult to move 30-year off-the-run bonds. New issue bonds generally performed well in the secondary market and caught a strong bid Thursday and Friday. For example, Amazon's (AMZN) (rating: A-, wide moat) 3.80% senior notes due 2024 tightened from their new issue spread of +155 to +144, Becton Dickinson's (BDX) (rating BBB+, narrow moat) new 10-year bond tightened 15 basis points to +135, and Medtronic's (MDT) (rating: A, wide moat) new 10-year bond tightened 17 basis points to +123. We were not surprised by the level of tightening, as our published fair value estimates on the new notes were +120, +140, and +115, respectively.

Although the new issues performed well and most sectors tightened a few basis points, the average spread of the Morningstar Corporate Index widened 1 basis point to +133. This is the widest level the index has registered this year and is at its widest since December 2013. The widening was predominantly driven by the energy sector, as rapidly declining oil prices have weighed heavily on the sector. Within our investment-grade bond index, the energy sector widened out 10 basis points last week and has widened out 52 basis points year to date. Similarly, the average spread of the Bank of America Merrill Lynch High Yield Master II Index widened almost 13 basis points to +477. Within the high-yield index, the energy sector had widened +100 basis points last week to +687 and has widened 300 basis points year to date.

While declining oil prices are pointing to difficulty in the energy sector, the immense increase of nonfarm payrolls to a consensus-shattering 321,000, along with a 0.4% increase in hourly wages, is pointing to a strengthening economy. The unemployment rate held steady at 5.8%. This payroll report was the single-largest monthly increase since 2012. Economic activity in the manufacturing sector also continues to expand at a rapid rate. For example, the ISM Manufacturing Index remained very strong at 57.8 and Markit's PMI Manufacturing Index slid slightly to 54.8. Both levels are well above the 50 demarcation between expansion and contraction. In addition, auto sales rose to a seasonally adjusted 17.1 million selling rate last month.

Even though inflation is still well below the Federal Reserve's target, with unemployment not that far from the Fed's longer-run estimate of central tendency for unemployment to run between 5.2% and 5.5%, it appears that it is getting increasingly harder for the Fed to justify keeping short-term rates at zero. The original intent was that the zero interest rate policy was to be an emergency measure to support the entire financial system in December 2008, and that this policy would only be kept in place during the financial crisis and would normalize soon thereafter. As such, while it's highly unlikely the Fed would begin to raise interest rates at the December meeting, it's likely that it will drop the language that it will maintain zero interest rates for a "considerable time." The market is pricing in a higher probability that rates will begin to rise by the middle of next year as the yield on the 2-year Treasury bond rose 10 basis points on Friday to 0.64%, its highest rate since April 2011. However, the 10-year Treasury has not risen at the same pace of the 2-year bond, resulting in a narrowing of the 2s10s curve. While we continue to expect that long-term interest rates will rise over time, in the short term, it appears that the 2s10s curve could continue to constrict further as the rise in the 2-year will outpace the rise in the 10-year.

As the pace of new issues begins to slow and trading in the secondary markets decelerates, we expect that credit spreads will grind tighter for the remainder of the year. Even though the Fed has wound down its asset-purchase program, we expect positive economic momentum will continue through the fourth quarter and forecast GDP growth will range between 2.0% and 2.5% in 2015. In addition, investment-grade and high-yield spread levels have some room to run as both are significantly wider than their tights from earlier this year. The tightest level our investment-grade bond index reached earlier this year was +101 on June 24, and the tightest the high-yield index reached was +335 on June 23.

New Issue Market Reaches New Volume Records
The new issue market roared back to life after Thanksgiving. There were several multi-billion-dollar deals, topped off by Medtronic's $17 billion multitranche offering, the largest single issuer offering this year. Year to date, the volume in the new issue market has surpassed last year's record-breaking issuance.

Clorox (CLX) (rating: A-, wide moat), which hadn't been in the new issue market for the past two years, issued $500 million 10-year notes at +125. Our fair value estimate of the notes is +110, which would place the spread just inside the A- tranche of the Morningstar Industrial Corporate Bond Index. Our issuer credit rating incorporates the firm's wide economic moat, which leads to a strong business risk score, moderate debt leverage, and consistent sales. Our wide moat rating is based on the firm's strong brands and market shares, as more than 80% of the firm's portfolio consists of number-one and number-two brands.

Among those issues that we thought were overpriced, American Express (AXP) (rating: A-, wide moat) issued $600 million subordinated notes due 2024 at +140 basis points over Treasuries. Our credit rating reflects the company's excellent loan-loss rate and delinquency profile compared with peers and its decreasing reliance on securitizations over the past few years; however, given the subordination of these notes, we estimated fair value to be +175 and see better value elsewhere in the financial sector. We also thought DirecTV's (rating: UR+/BBB, narrow moat) 10-year note was overvalued. The new notes priced at +175, whereas our fair value estimate was +185, given the uncertain future that still confronts DirecTV bondholders.

ECB Continues to Sit on Its Hands, but Promises to Act Early Next Year
At the December meeting, the European Central Bank decided to hold its monetary policy steady and did not change any of its key interest rates. The ECB did, however, reduce its forecasts for GDP growth in 2015 and 2016 once again. This month, it reduced the forecast from last month by 0.1 and 0.2 percentage point to 1.0%, and 1.5% for 2015 and 2016, respectively. These GDP growth forecasts are much lower than in March, when the ECB had forecast GDP growth of 1.5% in 2015 and 1.8% in 2016.

The ECB has begun purchases of covered bonds and asset-backed bonds and plans to continue these purchases over the next two years. In addition, the ECB will conduct the second targeted longer-term refinancing operation this week and will be followed by six more operations until June 2016. One change the ECB did make in its statement was that it "intends" to increase its balance sheet toward the size of what it was at the beginning of 2012, some $1 trillion higher. Previously, the ECB only "expected" that it would see an increase in the size of the balance sheet.

When asked about expanding the purchase program to include corporate and sovereign bonds, president Mario Draghi responded that the governing council would re-evaluate conditions early next year. He explained, "Should it become necessary to further address risks of too prolonged a period of low inflation, the governing council remains unanimous in its commitment to using additional unconventional instruments within its mandate…." and would alter "the size, the pace and the composition of our measures."

Irrespective of lingering questions regarding the legality of purchasing sovereign bonds in the secondary market given the ECB's prohibition against directly financing individual countries, bonds investors certainly took Draghi's remarks to mean that sovereign bond purchases are on the near-term horizon. Spanish and Italian bonds rose higher as the 10-year bonds of each country declined to their lowest ever yields of 1.83% and 1.98%, respectively. Both Spain and Italy are rated Baa2/BBB by the rating agencies, and the credit spreads on those bonds are now +104 and +119 basis points. Comparatively, the average spread of 7- to 10-year BBB rated corporate bonds in Morningstar's Eurobond Index is +123. If the ECB does not come through with a program to expand its asset-purchase program into sovereign bonds soon, then investors may begin to lose their trust in the ECB and we could quickly see these bonds widen dramatically. It was just only one year ago that both of these bonds were trading at levels more than double their current yield.

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