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Credit Insights

Rising Rates Reduce Returns

Payrolls and Other Economic Indicators Looking Better

Rising interest rates have pushed investment-grade returns into negative territory year to date. Last week, the yield on 5-year, 10-year, and 30-year Treasury bonds rose 25, 28, and 23 basis points, respectively to 1.74%, 2.40%, and 3.11%. As interest rates have risen to their highest yields thus far this year, the return of Morningstar Corporate Bond Index year-to-date total return has dropped to a loss of 0.48%. However, with its lower duration, and higher carry from much wider credit spreads, the return of the Bank of America Merrill Lynch High Yield Master II Index remains positive at 3.29%.

In the investment-grade space, the average spread of the Morningstar Corporate Bond Index held steady last week at +140 basis points and in the high yield space, the average spread widened 4 basis points to +456. Credit spreads were under pressure most of the week because of technical pressures as dealers looked to lighten up the amount of inventory that has built up on their books over the past few months. While the new issue market slowed down as the summer slowdown takes hold, activity was brisk in the secondary market. Dealers reportedly sold over $3.5 billion worth of bonds from their inventory over the course of the week, with over one third of the volume consisting of long-duration bonds. Once the average yield on 30-year corporate bonds rose back above 4.50%, demand increased for this long-duration paper from insurance companies and pension funds.

With the rise in interest rates, the all-in yield of the Morningstar Corporate Bond Index rose to 3.28%, its highest yield since September 2013. Although still lower than to where it spiked at the end of last year, the yield in the high yield index rose to 6.29%. The higher all-in yields have begun to pique investor interest as indicated by high yield fund flows for mutual funds and ETFs, which rose by $1.3 billion last week, its strongest weekly inflow since early February.

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. 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 2015 GDP growth to range between 2.0% and 2.5%. 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 ECB only in 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 have a negative impact on 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.

Payrolls and Other Economic Indicators Looking Better
Economic indicators looked stronger across the board last week as temporary factors that hindered the economy in the first quarter have subsided. The metric that had the most impact on the bond market was the employment report released last Friday. Nonfarm payrolls rose by 280,000 in May, a significant increase over expectations. In addition to the strong employment report, auto sales rose to a seasonally adjusted selling rate of 17.7 million units, which is the highest reading since July 2005. Strength was also seen in rising construction spending, improving manufacturing statistics, and a sharp improvement in the trade deficit for April.

It appears that economic improvement should continue over the near term. The Institute for Supply Management  Purchasing Managers Index report improved to 52.8 in May from 51.5 in April. A reading above 50 indicates economic expansion, whereas below 50 indicates contraction. Based on the prior few durable goods order reports, we had thought the worst of the slowdown in the manufactured had already bottomed out and this report seems to confirm that suspicion. According to the ISM, if the May reading of PMI is annualized, it would equate to a 3% annual rate of increase in GDP.

After the disappointing economic contraction in the first quarter, investors had begun to assume that the Fed was still a long way from raising interest rates. However, the strength of these reports has changed that view. With the economy seemingly back on track, the probability that the Fed will begin to hike rates later this year is significantly higher than it was just a few short weeks ago. As such, interest rates rose dramatically. Investors are requiring a higher level of interest rates to offset the higher probability of rising short-term rates in the near term. 

It appears that economic improvement should continue over the near term. The Institute for Supply Management Purchasing Managers Index report improved to 52.8 in May from 51.5 in April. A reading above 50 indicates economic expansion, whereas below 50 indicates contraction. Based on the prior few durable goods order reports, we had thought the worst of the slowdown in the manufactured had already bottomed out and this report seems to confirm that suspicion. According to the ISM, if the May reading of PMI is annualized, it would equate to a 3% annual rate of increase in GDP.

After the disappointing economic contraction in the first quarter, investors had begun to assume that the Fed was still a long way from raising interest rates. However, the strength of these reports has changed that view. With the economy seemingly back on track, the probability that the Fed will begin to hike rates later this year is significantly higher than it was just a few short weeks ago. As such, interest rates rose dramatically. Investors are requiring a higher level of interest rates to offset the higher probability of rising short-term rates in the near term.

Greece and Its Creditors Continue to Negotiate as Near-Term Payments Loom Closer
Considering Greece was unable to meet a debt payment last week and bundled that payment with other payments due later this month, it appears that it has run out of cash and is rapidly running out of time. 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. Currently, after restructuring most of its debt and drawing down upon the loans from official creditors, almost 80% of Greece's debt is now held by organizations such as the IMF, EFSF, 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.

Chinese Stocks Looking Bubblicious; Emerging Market Bonds Susceptible if It Pops
Over the past month, the Shanghai Index has risen 12%, 55% year-to-date, and 147% over the past 52 weeks. Yet, in the face of equity prices skyrocketing, economic activity has been waning. While the Chinese economy had reportedly grown at a 7% rate in the first quarter, that pace of growth was a sequential decrease from the 7.3% growth rate recorded in the third and fourth quarters of 2014 and a decline from the 7.5% growth 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 Manufacturing Purchasing Managers Index remains below 50, which is the demarcation between growth and contraction. In May, the index rose slightly to 49.2 from 48.9 in April, but is the third consecutive reading below 50. The Services PMI reading rose to 53.5 from 52.9 in April, but with manufacturing a greater percentage of the country's economy, the Composite Index slipped slightly to 51.2 from 51.3.



In order to combat a slowdown in the Chinese economy, China's central bank began to ease monetary policy as it cut its benchmark lending rate in November 2014, its first reduction since 2012. This cut was soon followed by another reduction in February and again in May. In addition to the rate cuts, the central bank has also lowered its reserve requirement ratio this year. Furthermore, the central bank has lowered the down payment required for a second home in an attempt to bolster dwindling property prices. However, these rate cuts and lower reserve requirements have not been enough to stimulate the Chinese economy. A few weeks ago, policymakers also instituted program to swap short-term loans to local governments for long-term bonds that can be pledged as collateral with the central bank for low cost financing in order to free up liquidity and take pressure off of refinancing near-term debt. 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.

With the property market in the doldrums, it appears that many investors have switched their preference from buying property to buying stocks. In fact, the number of new retail trading accounts being opened is currently multiple times higher than any point over the past eight years, including when the index was at its all-time highs in 2007. Anecdotal evidence is suggesting that many of the ingredients to form a bubble are currently in place. For example, in April a Bloomberg article cited, "the use of margin debt to trade in mainland shares has climbed to all-time highs, while investors are opening stock accounts at a record pace. More than two thirds of new investors have never attended or graduated from high school."

Chinese policymakers will need to walk a tightrope as they manage monetary policy. On the one hand, easing monetary conditions further may help to prop up a flagging economy; however, too much easing risks stoking the speculative equity bubble even further. The higher equities rise, the more severe the potential negative implications are for the broader Chinese economy. Considering China is the second-largest generator of global GDP, contagion from a sharp pop in their equity markets could spread to other markets and have negative international implications.

Thus far this year, emerging-market bonds have performed well. The Morningstar Emerging Markets Composite Bond Index has risen 3.06%. Underlying the composite index, the Morningstar Emerging Markets Sovereign Bond Index has risen 1.81% and the Morningstar Emerging Markets Corporate Bond Index has risen 3.97%. The Morningstar Emerging Markets High Yield Bond Index has risen 4.72%. However, emerging markets are notoriously known for being an extremely volatile asset class in a "risk-off" scenario. For example, in 2013, the Morningstar Emerging Markets Composite Bond Index fell 4.43% as investors looked to repatriate cash during the taper tantrum (when interest rates rose sharply as the market priced in the end of the Fed's asset purchase program). Investors in emerging-market bonds should keep an eye on the Shanghai index. If it suffers a strong correction, the risk-off sentiment is likely to sweep across all assets in the emerging markets.