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Credit Insights

Relatively Quiet Week Allows Repositioning Ahead of Quarterly Earnings

Pace of economic growth in China slows; investors bet on additional easing.

Corporate credit spreads traded sideways for most of last week and widened slightly Friday as the equity markets took a hit. The average spread of the Morningstar Corporate Bond Index widened 2 basis points to +132 by the end of the day Friday, and the Bank of America Merrill Lynch High Yield Index widened 6 basis points to +466. A few new issues were priced in the financial sector during the week after the larger banks reported earnings, but the pace of new issue volume remained substantially below the deluge of new bonds brought to market in February and March. Even though earnings season officially began last week, news flow was relatively modest as the preponderance of earnings reports begin in earnest this week. With new issue volume low and headlines quiet, portfolio managers and traders used the opportunity to move bonds around and reposition their portfolios. The main theme we heard was duration extension trades, as some investors looked to lengthen their portfolios from a 5-year average life to closer to 7 years. However, even with some investors lengthening their portfolios, there was no shortage of bids for short-dated paper. European and Japanese investors who have been buying short-dated paper over the past few months continued to reallocate assets from bonds denominated in euros and yen into U.S. dollars. By swapping out of lower-yielding fixed-income securities denominated in euros, these investors are able pick up the higher all-in yield that U.S. corporate bonds offer and invest in the safety of the strengthening dollar.

Treasury bonds rallied over the course of the week. On the longer end of the curve, the 5-year Treasury tightened 11 basis points to 1.29%, the 10-year Treasury tightened 10 basis points to 1.85%, and the 30-year Treasury tightened 8 basis points to 2.50%. The combination of weak economic releases along with dovish commentary from several Fed members prompted investors to bet against an increase in the federal funds rate in June and assume that the Fed will stay lower for longer; however, this hypothesis will be tested over the next few months. Investors will need to keep a sharp eye on the next few economic releases. While the Fed has cited lower-than-targeted inflation as one of the reasons to keep a zero-interest-rate policy in place, the consumer price index revealed that on a year-over-year basis, core inflation excluding energy has still risen at a 1.8% pace, not that far from the Fed's 2% target. With oil prices stabilizing and expected to rise in the second half of the year, headline inflation should also rise. In addition, with unemployment already down to 5.5%, if the economic weakness over the past few months has really been driven by worse-than-usual weather and the economy rebounds, it will be increasingly difficult for the Fed to rationalize keeping interest rates at zero.

While the average credit spread of high-yield corporate bond index widened slightly, rising oil prices boosted bond prices in the high-yield energy sector. In the Bank of America Merrill Lynch High Yield Master Index, the average spread of the energy sector tightened 17 basis points to +676. This tightening was driven by the increase in oil prices to $56 a barrel from $52. The energy sector has outperformed the rest of the corporate bond market universe thus far this year. Since our Jan. 12 publication, in which we noted that oil prices had appeared to bottom out in the mid-$40s, the investment-grade energy sector has tightened a total of 65 basis points and the high-yield energy sector has tightened 127 basis points.

High-yield mutual funds and exchange-traded funds experienced another week of positive inflows, although the pace of inflows slowed from the prior week.

Europe QE to Continue; German 10-Year Bund Yield on Its Way to Negative
There was no new news emanating from the recent European Central Bank meeting. Quantitative easing will continue on pace, and yields on sovereign bonds have continued to constrict. The yield on the 10-year German bund dropped to as low at 0.05%, seemingly on its way to a negative yield, before rebounding slightly and ending the week at 0.08%. Elsewhere in the eurozone, interest rates across Europe continue to trade at or near their historical lows. The yield on French 10-year OATS dropped further to 0.37%, and the Swiss 10-year bond ended the week at a yield of negative 0.15%. Yields rose slightly among the lower-rated peripheral eurozone countries such as Italy and Spain, as credit spreads on the Italian and Spanish bonds widened modestly. Some investors are becoming concerned that if Greece exits the eurozone, it could pave the way for other countries to exit in the future. While this may be a concern at some point, so long as Italy and Spain can issue debt at minuscule interest rates (currently below 1.50%) while the ECB runs its bond-buying program for 16 months, there is no reason for either country to consider exiting.

As Greece nears the point at which it needs to meet upcoming debt payments, the headlines are ramping up that the country is running out of time and options. While this raises the specter of Grexit (the country's exit from the eurozone), the current situation is nothing like it was in 2010 when a Greek default had the potential to initiate systemic risk in the financial system. Back then, Greek debt was widely held throughout the European banking system, yet no one knew exactly who held how much. Banks were concerned that even if they did not hold Greek debt themselves, a Greek default could weaken the solvency of other banks to which they had counterparty risk. Currently, after restructuring most of the debt and drawing down upon the loans from official creditors, almost 80% of Greece's debt is now held by organizations such as the International Monetary Fund, European Financial Stability Facility, and ECB. As such, the credit counterparty risk is no longer borne by the banking system and would not instigate the same systemic concerns that rippled through the financial markets as before.

There is reportedly more than EUR 2 trillion of euro area government bonds that are currently trading at negative yields. Most of these bonds are issued from the core European governments with maturities of up to 9 years. By purchasing a bond at a price that would generate a negative yield if held to maturity, investors are locking in a guaranteed loss if they hold the bonds until they are repaid. Fundamentally, this would only make economic sense is if an investor is expecting a significant deflationary event that would decimate other asset values across the world. Otherwise, the only way for an investor to make money on these bonds is to sell them to another investor at a price that locks in an even greater loss. In this case, speculators are expecting that they will be able to sell the bonds to the ECB, which has stated that it would buy debt trading at a negative yield.

Considering interest rates on sovereign bonds in developed markets are near their historically lowest levels, we think corporate bonds should perform well on a relative basis. The proceeds from the ECB's purchase of sovereign debt and asset-backed securities will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand will probably drive corporate credit spreads tighter. As corporate credit spreads in Europe contract, we think this will pull credit spreads tighter in the United States as well.

Pace of Economic Growth in China Slows; Investors Bet on Additional Easing
China reported that its GDP rate grew 7.0% year over year in the first quarter. This is a decrease from the 7.3% rate recorded in the third and fourth quarters of 2014 and the 7.5% growth rate in the second quarter and 7.4% in the first quarter. To combat the economic slowdown, China's central bank cut its benchmark lending rate in November 2014, its first reduction since 2012. This cut was followed by another reduction in February 2015. In addition to the rate cuts, the central bank has eased some regulations, such as lowering the down payment required for a second home in an attempt to bolster property prices.

At the end of March, China's central bank governor publicly remarked that China's growth and inflation rates are declining too much and that the central bank has the capacity to ease additional policies and lower interest rates even further. His statements bolster the Street's consensus forecast that China's central bank will cut benchmark lending rates as well as lower banks' required reserve ratios in the near term. Speculation is building that China is close to launching its own quantitative easing program in order to further loosen monetary policy.

With the property market in the doldrums, it appears that many Chinese investors have switched their preference from buying property to buying stocks. Chinese policymakers will need to walk a tightrope over the next several months. Easing monetary conditions may help to prop up a flagging economy; however, too much easing risks stoking a speculative equity bubble, which when it pops may not only have severe implications for the Chinese economy, but could have international implications as well, considering that China is the second-largest generator of global GDP.

Last week we highlighted the parabolic rise in the Shanghai Index and that the levitation in Chinese stocks was starting to pull stocks in the Hang Seng Index upward as well. The Shanghai Index rose another 6.3% last week and the Hang Seng rose 1.4%. However, after those markets closed, the Chinese government announced that it would allow an increase the number of securities that can be shorted and tightened regulations regarding the use of certain assets to be used in margin trading. Futures on the Shanghai dropped as much as 7% after the announcement before rebounding slightly. Whether this is the beginning of a correction or a bear market trap remains to be seen.