Credit Spreads Weaken as Investors Weigh Losses Across Fixed-Income Classes
Retail sales strong enough to raise economic forecasts, but not high enough to prompt Fed to raise rates this month.
Trading action in the corporate bond markets was squishy last week. There were several short bouts of buying activity and decent liquidity in the secondary markets, only to quickly disappear and remain moribund for the remainder of the day. Investors were especially conscious of the all-in yields as buyers of corporate bonds emerged when underlying interest rates rose, yet these same buyers quickly disappeared when interest rates dropped. In addition, the ends of the yield curve traded well, but the middle of the curve struggled. Short-term bonds with maturities of 5 years and less were well bid and long-term bonds with maturities of 30 years were met with strong demand, but the intermediate part of the curve from 5 to 10 years struggled to find buyers. Over the course of the week, spreads were weaker more often than not, and the average spread of the Morningstar Corporate Bond Index widened 3 basis points to end the week at +143. In the high-yield space, the average spread of the Bank of America Merrill Lynch High Yield Index widened 7 basis points to +463. In conjunction with widening credit spreads, high-yield mutual funds and exchange-traded funds suffered their third-greatest weekly outflow over the past year.
After steadily rising for the past few weeks, interest rates have finally increased enough to find buyers. Yields had risen through last Wednesday, but quickly turned around Thursday and held steady Friday. However, year to date, the increase in interest rates has pushed fixed-income indexes into negative territory. The longer end of the curve has risen the most as the 5-year Treasury has risen only 8 basis points to 1.73%, whereas the 10-year has risen 22 basis points and the 30-year Treasury has risen 35 basis points with the yield on those last two bonds currently at 2.39% and 3.10%, respectively. As rising rates have pushed bond prices down, this has erased the amount of yield carry that bonds have generated thus far this year. For example, the Morningstar Core Bond Index, our broadest measure of the fixed-income markets, has declined 0.12% year to date. Within this broad index, our Government Bond Index has lost 0.36% and our Investment-Grade Corporate Bond Index has declined 0.50%.
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 depends more 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 level of growth should be enough to hold down default rates, which will in turn support the high-yield market.
Retail Sales Strong Enough to Raise Economic Forecasts,
but Not High Enough to Prompt Fed to Raise Rates This Month
Of the economic indicators released last week, investors focused the most on the retail sales report. In May, retail sales rose a solid 1.2% compared with April. Even excluding the increase from rising auto and gasoline sales, retail sales rose 0.7%. In addition, the March and April sales reports were revised higher. This in turn will support GDP growth estimates for the second quarter. Morningstar's Johnson said second-quarter GDP growth may exceed his current forecast of 2.5%-3.0%. The sales growth was strong enough that it boosted the GDPNow forecast for second-quarter economic growth as provided by the Federal Reserve Bank of Atlanta to 1.9% from 1.5%. Johnson also noted that net worth has increased by $1.3 trillion in the first quarter to $84.9 trillion and that the wealth affect from the higher net worth should help support consumer spending in the near term.
While the retail sales report was strong enough to lift economic expectations, it probably was not high enough to persuade the Federal Reserve to raise its fed funds rate at its June meeting held this week. On a year-over-year basis excluding autos and gasoline, non-inflation-adjusted sales rose approximately 4%. This is within the range of the same slow and steady growth rate at which sales have expanded on a year-over-year basis over the past year.
Shot Clock Running Out on Greece; EU Reportedly Preparing for Default
Considering that Greece was unable to meet a debt payment two weeks ago and bundled that payment with other payments due later this month, it appears the country has run out of cash and is rapidly running out of time. Given the increase of the number of stories in the media that the European Union is preparing for a Greek default, we think the amount of time that Greece has to negotiate a new financing plan is rapidly diminishing. As the negotiations have been dragging on, seemingly with very little progress, many participants appear to be increasingly losing patience.
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, but 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 Greece has restructured most of its debt and drawn down on the loans from official creditors, almost 80% of its debt is now held by organizations such as the International Monetary Fund, European Financial Stability Facility, and European Central Bank. 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.