Corporate Credit Spreads Widen; High Yield Outperforming Investment Grade Thus Far This Year
Economic contraction in first quarter should prove to be an anomaly.
Corporate credit spreads weakened last week as economic news was generally disappointing and the equity markets sold off. In the investment-grade space, the average spread of the Morningstar Corporate Bond Index widened 6 basis points to +141. In the high-yield space, the average spread of the Bank of America Merrill Lynch High Yield Master II Index widened 5 basis points to +452. Since the end of last year, investment-grade bond spreads have given back all of their prior gains and are 1 basis point wider. Credit spreads in high yield are still 52 basis points tighter than the end of last year.
In our first-quarter outlook published late last year, we made our case on why we expected high yield to outperform investment grade this year. Year to date, the high-yield index has returned 4.06%, whereas the investment-grade index has only returned 0.99%. Much of the outperformance has been driven by the recovery in the energy sector. In our Jan. 12 publication, we noted that per-barrel oil prices had appeared to bottom out in the mid-$40s. Since then, oil has risen to over $60 and ended last week at $60.30. As oil prices rebounded, so did bonds in the energy sector. In our investment-grade index, the average credit spread in the energy sector tightened 45 basis points to +189, and in the high-yield market, credit spreads in the energy sector have tightened 113 basis points to +643. After increasing steadily over the past few months, it appears that the rise in oil prices is slowing. As such, the relative outperformance of the energy sector as compared with the rest of the index will diminish, thus potentially limiting further gains over the next few months.
Although much of the outperformance we expected in high yield for this year has already occurred, we continue to expect that high-yield bonds 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. Even though the contraction in GDP for the first quarter was disappointing, Robert Johnson, Morningstar's director of economic analysis, projects full-year GDP growth of 2.0%-2.5%. This should be enough to hold down default rates, which will in turn support the high-yield market.
In addition, with the European Central Bank only entering the third 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 would pull forward some of its asset purchases and increase the pace of purchases in June and July. This action is in anticipation of lower trading activity in the fall, which would negatively affect the ECB's ability to transact and could cause heightened volatility. This demand for corporate bonds will support the bond market in both Europe and the United States.
Between disappointing economic reports and the continual barrage of headlines surrounding Greece's attempts to refinance near-term debt maturities, investors remained on the sidelines. Fund flows in high-yield open-end funds and exchange-traded funds were almost unchanged last week, falling by $0.1 billion.
As Greece has run out of the cash 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 (Greece's exit from the eurozone), and a Greek default may cause some near-term volatility in the market, we do not foresee it instigating systemic problems in the financial system. In our view, the current situation is nothing like it was in 2010, when a Greek default had the potential to initiate systemic risk and counterparty failures 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. Now that Greece has restructured most of its debt and drawn down the loans from official creditors, almost 80% of its debt is 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.
Economic Contraction in First Quarter Should Prove to Be an Anomaly
In the revision to gross domestic product for the first quarter, GDP was lowered to negative 0.7% from the original estimate of 0.2%. This reading is only the third time GDP has contracted since the recession (the first quarters of 2011 and 2013 were the other quarters of contraction). Similar to the prior contractionary quarters, growth is expected to rebound as temporary factors are alleviated. A substantial amount of the economic decline was due to the West Coast port strike, the strengthening of the U.S. dollar versus other currencies, and unusually severe winter weather in some regions. These factors led to the largest revisions, which were split between a higher-than-expected surge in imports (as the port strikes ended and the backlog of ships were unloaded) and a reduction in inventory buildup. In addition, while declining oil prices should have positive economic impacts over the medium term, in the near term declining oil rig drilling and lower demand for oil drilling supplies pressured the economy.
Morningstar's Johnson continues to forecast that GDP will expand at 2.0%-2.5% for the full year. That implies that growth over the next three quarters will average around 3%. Johnson further expects GDP growth next year could accelerate slightly to 2.25%-2.75%. In his view, labor scarcity will lead to improvements in wage gains and allow consumer spending to rise. For further detail on first-quarter GDP and Johnson's outlook, please see his most recent article, "GDP Will Bounce Back."