High-Yield Bonds Should Continue to Outperform Moribund Investment-Grade Market
Rise in core CPI stokes inflation fears.
A respectable amount of new issues priced last week as corporations looked to tap the capital markets before the Memorial Day weekend. Typically, Memorial Day marks the beginning of the seasonal summer slowdown; however, according to several sources there remains a relatively heavy new issue shadow calendar looking to price new transactions this week. This shadow calendar is composed of a combination of financing required to fund announced strategic acquisitions as well as opportunistic transactions looking to lock in low-cost long-term debt to fund share repurchases before interest rates rise any further.
While the equity market hit an all-time high, corporate credit spreads in the investment-grade sector continued to trade within a relatively narrow range. Since the beginning of April, the average spread in the Morningstar Corporate Bond Index has varied by only 6 basis points from high to low and ended last week at +135. Since the beginning of the year, the average spread has tightened only 5 basis points. While the investment-grade market has been relatively stagnant, credit spreads in the high-yield market have tightened appreciably. 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. Since then, the average spread of the Bank of America High Yield Index has tightened 57 basis points to +447.
We continue to expect that high-yield bonds will provide a better return than investment grade this year. The high-yield segment has a much lower correlation to underlying interest rates than investment-grade bonds and is more dependent on economic conditions. Even though first-quarter GDP growth was disappointing, Robert Johnson, Morningstar's director of economic analysis, projects full-year GDP growth to range between 2% and 2.5%. Based on his expectation that the first-quarter growth rate is likely to be revised down even further, in order to reach his forecast GDP growth will have to average over 3% for the remainder of the year. This level of growth should be enough to hold down default rates, which will in turn support the high-yield market.
In addition, with the European Central Bank in just 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. Recently, the ECB announced that it will pull forward some of its asset purchases and increase the pace of purchases over the next two months. This action is in anticipation of lower trading activity in the fall, which would negatively affect the ECB's ability to conduct transactions and could cause heightened volatility. This demand for corporate bonds is likely to drive corporate credit spreads in both Europe and the United States tighter.
As we expected the prior week, with the stock market bumping against its all-time highs and the rise in interest rates moderating, high-yield fund flows turned around and rose $0.8 billion last week after suffering four weeks of consecutive outflows.
Rise in Core CPI Stokes Inflation Fears
While the headline reading for the consumer price index for April was a moderate 0.1%, CPI excluding food and energy rose faster than expected. On a month-over-month basis, CPI less food and energy rose 0.3% and on a year-over-year basis, it rose 1.8%. Although the Fed's preferred measure of inflation may be the personal consumption expenditure index, the core CPI reading remains close to the Fed's targeted inflation rate of 2%. The higher reading was driven by a 0.7% month-over-month increase in the medical care index as well as a 0.6% increase in used vehicles and 0.5% increase in household furnishings. Low oil prices have helped keep overall inflation levels low since last fall, but with oil prices stabilizing, the downward pressure on inflation will start to abate in the second half of the year. Based on director of economic analysis Johnson's calculations, if core inflation remains at 1.8% and gasoline prices stay where they are now (30% off their recent lows), the total inflation rate could rise to 2.2% in December and 3% in January and February 2016.
In a speech by Fed Chair Janet Yellen on Friday, she asserted her opinion that the economic slowdown in the first quarter was an aberration driven by temporary factors such as record-cold weather in the Northeast and port strikes on the West Coast. She also highlighted that statistical smoothing factors used to adjust for seasonal factors may have overstated the typical slowdown in the first quarter. If she is correct and the economy quickly bounces back, an economic rebound in conjunction with core CPI rising faster than expected and unemployment at 5.4% may pressure the Fed to begin raising interest rates this fall.