Corporate Credit Spreads Hold Steady in the Face of Rising Interest Rates
Weak retail sales report calls expected economic rebound into question.
After steadily rising over the previous three weeks, the yield on the 10-year Treasury peaked at 2.28% Wednesday before rebounding and ending the week at 2.14%. As interest rates rose, corporate bonds have given back a significant amount of the gains they generated earlier this year. In mid-April, the year-to-date return of the Morningstar Corporate Bond Index had risen to 3.08%; however, rising interest rates have erased much of that gain, pushing bond prices down so much that as of May 15, the index has risen only 1.14% for the year. Comparatively, the Morningstar US Government Bond Index has risen only 0.65% year to date. With their lower correlation to underlying interest rates, high-yield bonds have held their value better over the past month. The Bank of America High Yield Master Index has risen 3.91% year to date, giving up only a small portion of its earlier gains after being up as much as 3.95% in April.
During the 2013 "taper tantrum," when interest rates rose precipitously after then-Chairman Ben Bernanke indicated that the Federal Reserve was nearing the time it would halt its asset-purchase program, corporate credit spreads widened significantly as portfolio managers attempted to dodge falling bond prices; however, over the past month as interest rates have risen, corporate credit spreads have traded in a very narrow range of only 4 basis points. As of May 15, the average spread of the Morningstar Corporate Bond Index is +134 basis points over Treasuries, compared with +131 in mid-April. In the high-yield market, the Bank of America Merrill Lynch High Yield Index ended the week at +455, only 2 basis points tighter than mid-April.
Even though underlying interest rates have risen, we continue to expect corporate bonds will outperform U.S. Treasuries and other developed-market sovereign bonds for the rest of the year. With the European Central Bank in only the second month of its planned 18-month asset-purchase program, those proceeds will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand is likely to drive corporate credit spreads in both Europe and the United States tighter. In our first-quarter outlook published late last year, we made our case on why we expected the high-yield market to outperform investment grade this year. We continue to expect that high yield will provide a better return than investment grade. The high-yield segment has a much lower correlation to underlying interest rates than investment-grade bonds and is more dependent on economic conditions. Based on our expectation that economic growth will rebound from the first quarter to 2.0%-2.5%, this level of growth should be enough to hold down default rates, which will in turn support the high-yield market.
After suffering a $2 billion outflow the prior week, investors pulled only $0.4 billion from high-yield open-end mutual funds and exchange-traded funds last week. With the stock market bumping against its all-time highs and the rise in interest rates moderating, we expect high-yield fund flows will turn around this week.
Weak Retail Sales Report Calls Expected Economic Rebound Into Question
Among the economic indicators released last week, the retail sales report garnered the most attention. Overall retail sales were unchanged in April as compared to consensus expectations of a 0.2% gain. Even excluding some of the more volatile components such as auto sales, gasoline, and building materials, retail sales growth was flat. Unlike last spring when sales quickly rebounded after an unseasonably harsh winter, flat sales this year are calling into question whether the economy will bounce back this spring. Compounded with other weaker than expected economic metrics, such as the middling growth in the payrolls report earlier this month, it appears that the Fed has more than enough evidence to warrant holding off increasing interest rates until September as opposed to June.
Chinese Debt-for-Bond Swap Program Will Add More Monetary Stimulus to Stoke Economic Growth
Following the recent interest rate cut, Chinese officials are continuing to implement additional stimulus programs in an attempt to rekindle economic growth. On May 10, the Chinese central bank cut the one-year benchmark lending rate by 25 basis points to 5.1% and cut the deposit rate by 25 basis points to 2.25%. This is the third rate cut since November and comes on the heels of the central bank's cut to the reserve requirement ratio a few weeks ago. In addition to the interest rate cut, China is reportedly launching a program to swap short-term loans to local governments for long-term bonds. The bonds can then be used as collateral with the central bank for low-cost financing. This program will lengthen the maturities of local government loans, reduce interest rates on the debt owed by these local governments, and free up capital to make new loans.
While the Chinese economy reportedly grew at a 7% rate in the first quarter, that pace was a decrease from the 7.3% rate recorded in the third and fourth quarters of 2014 and the 7.5% rate in the second quarter and 7.4% in the first quarter. Recent economic indicators also show that the Chinese economy is continuing to decelerate. For example, Markit's HSBC China Composite Output Index dropped to its lowest level in the past three months with a reading of 51.3, a sequential decline from 51.8 last month. A reading of 50 is the demarcation between economic expansion and contraction. The lower composite reading was mainly based on stagnation in the manufacturing sector as the manufacturing PMI has fallen to 48.9; however, this was partially offset by a rise in the services PMI, which rose to 52.9.
Economic Growth Across Euro Area Remains Positive, but Still Sluggish
The economy across the euro area continued to expand during the first quarter, although at a very moderate pace. Seasonally adjusted GDP rose 0.4% in the first quarter from the prior quarter. This pace of economic expansion is slightly faster than the 0.3% rate in the fourth quarter of 2014. Compared with the same quarter of the previous year, GDP rose 1.0%. The weaker euro, lower energy prices, and low interest rates were all cited as reasons that drove growth during the quarter.
For the third quarter in a row, economic expansion in Spain accelerated. Spain reported that its GDP rose 0.9% in the first quarter compared with 0.7% in the fourth quarter and 0.5% in the third quarter. Germany, which has long been the economic powerhouse of the euro area, registered slightly less than average as its GDP rose 0.3%, a marked slowdown from the 0.7% it posted in the prior quarter. Economic growth in France, the second-largest economy in the euro area, rebounded from being flat in the fourth quarter last year to expanding 0.6% in the first quarter. The Italian economy also rebounded in the first quarter, albeit to a lesser degree. Italian GDP rose 0.3% as compared with no growth in the prior quarter. Economic growth in beleaguered Greece decreased 0.2%; this was the second consecutive quarter of contraction as GDP fell 0.4% last quarter. The deteriorating economy further complicates Greece's attempts to renegotiate its debt payments as the lower GDP calls into question the country's ability to handle its debt load and may force Greece to exit the euro area.
Even if Greece is unable to successfully renegotiate its debt repayments, we do not think this will lead to a systemic financial shock. In our view, 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 on the loans from official creditors, almost 80% of Greece's debt is now held by organizations such as the International Monetary Fund, ECB, and European Financial Stability Facility. 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.